Are annuities a good investment?
An annuity is a type of investment you can purchase from an insurance company. But what exactly are annuities, and are they a good investment choice? This article will explain in simple terms what annuities are, the pros and cons, the different types available, and whether an annuity is right for you.
Annuity Basics
Let’s start with the basics – what is an annuity?
An annuity is a contract you make with an insurance company. You pay them a lump sum of money upfront, or multiple payments over time. In exchange, the insurance company guarantees to provide you with regular periodic payments in the future.
The main goals of an annuity are to provide steady retirement income that you cannot outlive, and protect you against the risk of running out of money later in life. Annuities can give you peace of mind knowing you’ll have guaranteed income for as long as you need it.
How Do They Work?
With an annuity, you’re able to invest a lump sum of money with the insurance company (such as $100,000). The life insurance company then guarantees they’ll pay you a certain amount on a regular basis. For example, $500 per month for the rest of your life. Or $1,000 per month for 30 years.
Here is an overview of how annuities work in more detail:
- You either invest a single lump sum or make ongoing contributions over a period of time. This is known as the accumulation phase.
- The money inside the annuity grows tax-deferred. You pay no taxes on interest, dividends, or capital gains until you start taking withdrawals.
- At some point, usually retirement, you start the payout phase where you receive guaranteed income payments from the annuity. This can last a set number of years or for life.
- If you pass away before the payout phase finishes, the annuity’s remaining value goes to your chosen beneficiary as a death benefit.
- The insurance company handles investing the money in the annuity and guarantees the fixed payments. So you do not have to actively manage investments.
The guarantee of predictable income for life or a set period is the key benefit that annuities provide.
Different Types
Your future annuity payments from an annuity investment will be greatly influenced by the specific type of annuity you chose. There are several different types of annuities to choose from:
Fixed annuities – A fixed annuity provides a guaranteed, fixed rate of return and fixed income payments. The issuing insurance company bears the investment risk.
Variable annuities – A variable annuity is an income payment and account value fluctuates based on the performance of underlying investments. You assume the investment risk.
Indexed annuities – An indexed annuity offers a minimum guaranteed return plus the possibility of greater growth based on a market index.
Immediate annuities – An immediate annuity begins paying income immediately after you invest the lump sum amount.
Deferred annuities – A deferred annuity is an investment where income payments are delayed until a future date. The payee of a deferred income annuity, in contrast to a fixed annuity, can choose to delay the start of payments until a predetermined time.
Pros And Cons Of Annuities?
So should you invest your hard-earned money in an annuity? There are some key pros and cons to consider.
Pros
Guaranteed income for life: Annuities provide reliable income you cannot outlive. This protects against the risk of running out of money later in retirement.
Avoid market volatility: Fixed and indexed annuities allow you to avoid market ups and downs since your principal and earnings are protected.
Tax-deferred growth: You don’t pay taxes on earnings until you withdraw funds, allowing faster growth potential.
Death benefits: If you pass away before depletion, your beneficiary gets the remaining annuity value.
Flexibility: Some annuities allow you to structure payments to cover just certain periods.
Cons
Complex and expensive: Annuity contracts tend to have complex fees and surrender charges, making them pricier than other options.
Lose control over assets: Once payments start, you can’t access a lump sum or remaining value and lose control.
Limitation on withdrawals: Many annuities restrict how much you can withdraw without fees and penalties.
No stepped-up cost basis: Annuity Payments are fully taxed as income. They don’t receive a stepped-up basis like inherited assets.
Are they a Good Investment?
Not everyone should invest their hard-earned savings in an annuity. You need to evaluate your own specific situation.
Annuities are most appropriate for individuals who:
- Want reliable lifetime income in retirement
- Have a low-risk tolerance
- Don’t need access to a lump sum of cash
- Prefer to avoid stock market volatility
- Could benefit from tax-deferred growth
On the other hand, alternatives like bonds or mutual funds may be a better fit if you:
- Desire flexibility and access to your money
- Want to leave assets to your heirs
- Are comfortable actively investing on your own
- Don’t necessarily need guaranteed lifetime income
- Dislike long-term contracts and penalties
Think about your financial objectives, age, time horizon, risk appetite, and income needs as you decide if an annuity is right for you. They provide valuable benefits for some retirees, while others may be better served with different investments.
Buying an Annuity
If you decide an annuity supports your goals, here are some tips for purchasing one:
- Compare products – Evaluate the features, fees, and terms of different annuities side-by-side. Consider trade-offs.
- Assess financial needs – Think about your income needs, investment horizon, and risk comfort level. Make sure the annuity aligns.
- Work with a fiduciary advisor – Find a fee-only advisor who is legally required to put your best interests first.
- Avoid huge lump sums – Don’t invest all your savings in one annuity. Consider multiple smaller annuities.
- Ask about fees – Clearly understand any upfront costs, annual fees, surrender charges, etc.
- Read the contract! – Review the annuity contract closely before signing. Know the terms and limitations.
Taking your time to find the right annuity for your goals and circumstances can provide peace of mind that this long-term investment product is appropriate for you.
Alternatives
Annuities are not the only option to generate retirement income. Here are a few alternatives to consider:
Bonds – Provide fixed income payments for a set period of time. Lower risk than stocks.
Dividend stocks – Stocks that pay shareholders quarterly dividends that can provide an income stream for life.
Rental property – Income from rent payments can supplement retirement funds.
Mutual funds – Professionally managed funds that provide a diversified portfolio.
Individual retirement accounts (IRAs) – Tax-advantaged accounts for retirement savings.
Reverse mortgages – Allows you to access home equity as payments during retirement.
Each option has trade-offs to think about in terms of market risk, return, liquidity, taxes, and ongoing management. Talk to a financial advisor about integrating the right mix into your plan!
Making The Final Decision!
As you can see, annuities have some clear benefits but also come with drawbacks. How do you decide if purchasing an annuity is the right move? Here are some key steps:
- Objectively assess pros and cons – Consider the annuity advantages and limitations. How do these align with your needs?
- Compare to alternatives – Weigh an annuity versus other income-generating options. Look at the full picture.
- Evaluate total finances – Review current assets, income sources, tax situation, debts, and future goals.
- Calculate required income – Estimate your retirement income needs. Will an annuity help fulfill these?
- Review annually – Revisit your strategy as personal situations evolve. Make changes as needed.
Working with a fiduciary financial advisor can help analyze these factors and decide if an annuity has a place in your portfolio or if alternatives may be preferable. This independent guidance is invaluable for such an important decision!
Are They A Good Investment?
Annuities involve signing a long-term contract to exchange a lump sum payment for guaranteed future income from an insurance company. While not right for everyone, annuities can provide stability and peace of mind for retirees who want lifetime income with lower risk and don’t need access to a cash lump sum.
Take time to clearly understand the pros, cons, alternatives, and your own needs before making a decision. Seek out trusted professional advice to ensure an annuity aligns with your investment objectives and retirement plans.
