What is an Annuity?
An annuity is not a sexy investment. It is not high-risk nor high-reward. But, it does offer the peace of mind that you will not outlive your money. Here’s how it works:
The investor pays a series of payments, or a lumpsum to the insurance company. In return they pay money to the investor at regular intervals for the rest of their life. Annuities guarantee an income that is protected from bear markets. They are a popular choice for investors who want to set up a steady stream of reliable income. Also, your money can grow tax-deferred as long as you leave it in the annuity account. It is only taxed upon withdrawal. There are several different types of annuities, and each one serves a different purpose.
The Top Pros and Cons of Annuities
Annuities are the topic of great debate among financial professionals. On one hand, they offer guaranteed income no matter the economic climate. On the other hand, they have high fees which can lower the total return on your investment. Annuities have unique pros and cons.
The biggest pro of annuities is the guaranteed income stream. Many people successfully plan for retirement through other investment strategies. But the compelling case for annuities is that no matter what you cannot outlive your money. It is contractual and foolproof. That is not the case with other investment strategies.
Another benefit of annuities is that they are tax-deferred. That means you don’t have to pay taxes on your money in the account until withdrawal. At withdrawal you do have to pay ordinary income tax rates. Investors also use annuities for estate planning to limit taxes.
Unless you choose a variable annuity, annuities guarantee a predetermined return so you don’t have to worry about how the market performs. That dependability is the most obvious pro of annuities. Fixed index annuities allow you to enjoy some limited upside in the market without experiencing the loss. Our expert Marc Lichtenfeld writes, “If the market soars 20%, the investor will only make 4%. But if the market falls 20%, the investor won’t lose any money.”
The biggest con of annuities is the management fees the advisers charge their clients. Annuities are sold through insurance agents, or “advisers.” But the term adviser is a misnomer because many advisors don’t have a legal obligation to work in your best interests. They are simply salesman that want to sell you their product, the annuity.
Another con of annuities is that you give up liquidity. Let’s say your financial situation changes and you need some of the money you put into your annuity. You will be penalized and assessed surrender fees. You incur surrender fees if you try to withdrawal money within the surrender period which is typically 7 years, but can be much longer. Even when the income payments begin you cannot take out more than the contract states. If you want liquidity, annuities are bad choice.
A big selling point of annuities is their tax-deferred status. However, when you do withdrawal your money from the annuity it is taxed as ordinary income. This is a disadvantage because ordinary income tax rates are higher than some other tax rates. Other retirement accounts like a 401(k)s and IRAs can offer better tax savings.
It is worth noting that annuity sales declined once the government passed a law stating financial professionals had to act in the best interest of their clients. Before, brokers would push products with high commissions… and annuities have some of the highest commission rates. According to MarketWatch, when this law passed in 2016, sales of annuities fell 8%. They fell another 18% in the first quarter of 2017.
Types of Annuities
These are the four most important types of annuities: immediate, deferred, fixed, and variable. Let’s take a look at each one.
Immediate annuities are straightforward. You receive payments as soon as you make your initial investment. An immediate annuity is similar to the inverse of a life insurance policy. With life insurance policies you owe regular payments to the insurance company for a lump-sum payout upon your death. With immediate annuities you pay a lump-sum at the beginning in exchange for regular income payments until you die. Immediate annuities are popular among people who are already retired or soon to be retired. Also, deferred annuities can be changed to an immediate annuity.
Deferred annuities delay income payments until you elect to receive them. Deferred annuities have two phases: the saving phase, and the income phase. Unlike immediate annuities which require an initial lump-sum payment, deferred annuities allow you to invest money into the account over time. This is the saving phase. The income phase begins when you elect to receive payments. When you receive payments, this income will be taxed as ordinary income. Also, most annuity contracts guarantee certain minimum interest rates, regardless of market swings. The benefit of deferred annuities is that your money grows tax-free until withdrawal, usually upon retirement.
Fixed annuities are predictable and safe. They have a set payment amount each year. Because the payout amount is fixed, it is ideal for risk averse investors. Your capital is protected from the market if it goes south. But it also means missing out on market upswings and potentially larger profits. Fixed index annuities are the exception. Most fixed annuities are usually invested in government issued bonds or other such safe investments. But fixed index annuities are invested in index funds which allow you to profit from the stock market without losing on market downtrends. Fixed annuities can be immediate or deferred.
Compared to fixed annuities, variable annuities are the more aggressive investment. Their payments are based on the performance of the underlying investments, or the subaccounts. Your income stream will fluctuate as your subaccounts fluctuate in the market. Many people don’t like variable annuities because of their high maintenance fees. Suze Orman says, “I think variable annuities were created for one reason and one reason only—to make the advisor selling those variable annuities money.” Annuities generally offer an income stream that is safe and dependable. Variable annuities introduce risk into an otherwise risk averse investment choice.
Annuities offer a dependable income stream, but the fees, the lack of liquidity, and the taxed withdrawals limit investors’ flexibility. Our experts prefer dividend stocks over annuities. Find out how you can enjoy a wealthy retirement through dividend investing.