Planning for retirement can feel like a game of chess, where every move counts. One piece on the board that often comes up is the annuity. Some people swear by them, while others avoid them like the plague. So, are annuities good for retirement? The answer isn’t a simple yes or no—it depends on your financial situation, goals, and how you feel about things like security and flexibility. Let’s break it down.
What is an Annuity?
An annuity is a financial product that you buy from an insurance company. In exchange for a lump sum or a series of payments, the insurer promises to pay you a steady income for a set period of time—sometimes for the rest of your life. There are different types of annuities, but they all share this basic idea: trade your money now for income later.
Immediate Annuities vs. Deferred Annuities
Immediate annuity
Immediate annuities start paying out almost immediately after you make your lump sum payment. Since there is no gradual accumulation phase, you need to make one big lump payment to the insurance company (or possibly a few big ones, depending on the circumstances). Because of this mechanic, most immediate annuities are known as single premium immediate annuities (SPIAs).
SPIAs are often chosen by people at or near retirement who want to start receiving income right away. A person can for instance decide to put a part of their nest egg into a SPIA when they retire, to decrease risk and ensure a regular income stream now when they are no longer working.
SPIAs are also sometimes used by persons who suddenly recieved a lump sum of money, e.g. an inheritance, lottery win or damages, and want to prevent themselves from spending it quickly.
Deffered Annuity
The deferred annuity is the opposite of the immediate annuity. With a deferred annuity, you pay either a lump sum or many smaller monthly/yearly amounts. The insurance company will start paying you at a certain point in the future. This type of annuity can for instance be a way to guarantee income in your later retirement years.
Types of Annuities
Before diving into whether annuities are good for retirement, it’s important to understand the different types.
1. Fixed Annuities
These are the plain vanilla option. You give the insurance company a lump sum, and they agree to pay you a fixed amount of income for a certain period or for life. The payments are predictable and don’t change with the market, which is great for budgeting, but they may not keep pace with inflation.
2. Variable Annuities
With variable annuities, your money is invested in a selection of funds, often similar to mutual funds. The income you get depends on how those investments perform. This means you could end up with more money if the investments do well, but there’s also the risk of receiving less if they don’t.
With a variable annuity, your return is based on the performace of a basket of investment products, usually stocks and bonds. With many insurance providers, you are permitted to select investments for this basket – within certain limits.
Note: Some insurance providers will offer you to purchase a rider that ensures a guaranteed minimum withdrawal. This way, you have some protection if the investment basket does not perform well.
3. Indexed Annuities
These are a middle ground between fixed and variable annuities. Your returns are tied to a market index, like the S&P 500. While you’re protected from losing money (usually), your gains are capped. So, if the market goes up 10%, you might only get 5% of that. The idea of tying the annuity to an index is usually to make sure it keeps pace with inflation, so a broad index that is believed to represent the overall economy well is typically used.
Pros of Annuities for Retirement
1. Guaranteed Income
The biggest draw of annuities is that they can provide a guaranteed income stream for life. This can be incredibly reassuring, especially if you’re worried about outliving your savings. No matter what happens in the markets, you know you’ll have a steady income.
2. Tax-Deferred Growth
The money in a deferred annuity grows tax-deferred, meaning you don’t pay taxes on the earnings until you start receiving payments. This can be a big advantage if you’re in a higher tax bracket now than you expect to be in retirement.
3. Peace of Mind
For many, the predictability of an annuity is its greatest appeal. Unlike investments in the stock market, which can be volatile, an annuity can offer a sense of security, knowing that your income won’t dry up no matter how long you live.
4. No Contribution Limits
Many government savings schemes have annual contribution limits. This is for instance the case with the IRAs and 401(k) accounts in the United States. Typically, annuities don’t have any annual contribution limits, and this makes them an interesting option if you’ve maxed out your limited retirement accounts and still have money to invest.
Cons of Annuities for Retirement
1. Fees and Expenses
Annuities can be expensive. There are often high fees for things like management, mortality expenses, and optional riders (which are add-ons that provide extra benefits). These fees can eat into your returns and make the annuity less attractive. Having your money in an annuity is often more costly than keeping them in mutual funds, especially if you avoid the priciest of the actively managed funds.
Data from the United States show that it is not unusual for annuities in the U.S. to have annual expenses in excess of 2%. If you take out special riders, that will of cause bring the cost up even higher.
Note: Annuities are often sold through agents who earn commissions. If you purchase an annuity through an agent, you will typically be required to pay a substantial sales charge right away. This is (mostly) to cover the commission paid by the insurance company to the agent. If you are interested in an annuity, you can contact the insurance company directly – in many cases it is possible to avoid the sales charge when you do not use any agent.
2. Lack of Liquidity
Once you’ve put your money into an annuity, it’s not easy to get it back out. Most annuities come with hefty surrender charges if you withdraw funds early, especially in the first few years. This lack of liquidity can be a major downside if you need access to your cash.
Before you purchase an annuity, check how long the so called ”surrender period” is. If you make a withdrawal befor the surrender period is over, you will pay the surrender charge. It is common for the surrender period to be anywhere from six to eight years, although some policies have other rules so you should always check the fine print before committing to an annuity.
3. Complexity
Annuities can be complicated products with lots of fine print. Understanding the terms, fees, and potential payouts requires careful reading—and sometimes professional help. If you don’t fully understand what you’re buying, you could end up with a product that doesn’t meet your needs.
In the 21st century, a lot of new exotic versions of the traditional annuities have been launched, and they can be difficult to fully understand even for experienced investors.
4. Inflation Risk
Fixed annuities, in particular, can be vulnerable to inflation. If you lock in a fixed payment, that amount won’t increase even if the cost of living does. Over time, your purchasing power could decline significantly.
5. Taxes
In some jurisdictions, saving in an annuity provides tax-deferred status of your interest and investments gains. Many sellers of annuities will put this forward as a big selling point, and quickly gloss over how it works when it is time to recieve money from the annuity. Depending on the jurisdiction, any withdrawals and net returns you recieve from the annuity may be taxed as ordinary income. Depending on which tax bracket you are in, it could be higher than the capital gains tax. Make sure you understand the whole picture before you purchase an annuity.
Can I Lose My Money?
Annuities are considered very safe investments, but it is still possible to lose the money. You are putting your money in the hands of the insurance company, and just like any other company they can go out of business and default on their obligations.
It should be noted that in some countries, the government provides a type of protection for consumers in this situation, up to a certain upper limit. It is similar to the governmental guarantee that protects the money in your bank account, up to a certain limit, if the bank defaults. Make sure you understand applicable law before you invest.
Are Annuities Right for You?
Whether an annuity is a good fit for your retirement plan depends on your personal circumstances:
- If you’re risk-averse and like the idea of a guaranteed income for life, an annuity could be a good option.
- If you want flexibility and control over your investments, or if you’re comfortable managing your own retirement portfolio, an annuity might feel too restrictive.
- If you’re worried about outliving your savings, an annuity can provide peace of mind that you’ll have income no matter how long you live.
Final Thoughts
Annuities can be a valuable tool for securing income in retirement, but they’re not for everyone. The decision to buy an annuity should be made carefully, considering the fees, the complexity, and how it fits into your overall retirement plan. It might be worth consulting with a financial advisor to see if an annuity makes sense for you or if there are other strategies that might better meet your goals. Remember, the best retirement plan is one that’s tailored to your specific needs and financial situation. One popular compromise is to put your money in other investments, e.g. mutual funds and real estate, until you are close to retirement. As retirement approaches, you can move some of your nest egg into one or more annuities, perhaps even one with a downside protection rider if you want extra security.
This article was last updated on: September 24, 2024