An annuity is an insurance product that pays out income. You make an investment in the annuity and then it makes payments to you, giving you a dependable income stream during retirement.
Pros of Annuities
Annuities offer some considerable benefits over other kinds of retirement investments, especially for those not able or willing to risk losing a portion of their retirement savings.
Pros of annuities include:
- Lifetime Income – With an immediate lifetime annuity contract, you are guaranteed periodic payments for as long as you live. The “risk” of you living a long and happy life is borne by the insurance company providing the annuity.
Social Security and pensions offer a similar form of retirement income protection – but in limited dollar amounts. The only limit to the size of your periodic annuity payment is the amount of money you have to purchase an annuity now. Even better for many retirees, the older you are, the larger your monthly payments will be for the same price.
- Inflation Protection – You can customize annuities to ensure that your monthly paycheck will keep pace with the cost of living. This is critically important because inflation can have a devastating effect on your assets. The downside of an add-on like inflation protection is that it will cost more – in an initial cost or in lower starting payments to begin with.
- Principal Protection – One of the best features of fixed and equity indexed annuities is that the value of the annuity can be guaranteed to be at or above the amount invested. You can guarantee that you (or your heirs) will receive back at least as much money as you invested in the annuity.
- Tax Efficiency – The purchase of an annuity with qualified retirement savings (401k or IRA funds) can save you money on taxes over taking a lump sum payment. You can roll-over qualified funds into a qualified annuity without any tax penalties. You only pay taxes on the income the annuity provides.
- Predictability: According to a Towers Watson Retirement Survey, having predicable retirement income (presumably adequate income to cover all of your expenses) can help you feel happier. Lifetime annuities provide that kind predictability. Conversely, the researchers discovered that retirees who must withdraw money from investments to pay for retirement expenses had the highest financial anxiety.
In summary, an annuity is a great way to protect your quality of life in retirement. Your retirement assets can be efficiently used to purchase guaranteed income to last as long as you need. Best of all, this income can be protected from inflation and other financial woes.
So, What are the Cons of Annuities?
Despite the many advantages of annuities, they do have some downsides.
- Not All Annuities Are Created Equal – The financial planning community views some annuities – particularly fixed annuities – as being the ideal solution to a retiree’s need for guaranteed income. Fixed annuities have a very good reputation. However, other annuity products are viewed as “snake oil” – an unnecessary and expensive product. It is very important that you understand the various features and terms that are applied to annuities.
- Lower Returns on Your Investment – In return for the retirement income certainty provided by fixed annuities or equity indexed annuities you forgo the opportunity to make bigger returns by investing your money in assets that fluctuate in value, like stocks. A fixed annuity is considered to be a safe and conservative investment but this means that you will not see the possible gains (and losses) of a riskier investment – like the stock market.
- High Costs: Sales commissions and management fees are a common complaint about annuities. And, sometimes costs are definitely too high. When purchasing an annuity, it is recommended that you shop around and really know exactly what you are paying for.
- Inflexible – Annuities are also typically less flexible than other retirement options – once you purchase an annuity contract your capital is tied up in the annuity, so you don’t have access to that lump of money.
Some retirement financial planners recommend that people reserve at least 40 percent of their retirement assets for unforeseen circumstances. Because most annuities are designed to provide steady income over time, they are not ideally suited to cover large unplanned expenses.
(However, although undesirable, if circumstances require it, there are third party companies that will exchange a lump sum payment for your fixed income payments. In this situation you will likely end up receiving less than the amount you paid for the annuity.)
So, what do you think about the pros and cons of annuities for your retirement? Use an annuity calculator to estimate your income or see how an annuity fits into your overall retirement plan by using the NewRetirement Retirement Calculator.