An annuity is a contract issued by an insurance company that pays a stream of income for a specified period or often for the remaining life of the contract holder.
Annuities are often sold by insurance agents and registered representatives as an excellent way to provide income for their client’s retirement needs. But annuities have several pros and cons to consider before investing your retirement funds there.
How an annuity works
Annuities come in several main varieties, depending on how the money in the annuity is invested. Regardless of how the money is invested, though, it grows tax-deferred, and then all or a portion of it may be taxed when withdrawn. Annuities are purchased through a lump sum premium payment or many payments over time, perhaps over a career.
Annuities can be structured in many different ways, for example, to provide income for life to you and a spouse, to be taken out as a lump sum all at once or at various points in time. Some annuities may provide a death benefit on the owner’s passing.
The main types of annuities are:
- Variable annuities. Premium payments into a variable annuity are invested in one or more of the sub-accounts offered by the annuity. Sub-accounts are similar to mutual funds. The value of the annuity is determined by the performance of the sub-accounts.
- Fixed annuities. A fixed annuity guarantees a minimum rate on the premium dollars invested. The rate can be reset periodically over time or even annually.
- Indexed annuities. An indexed annuity tracks an index like the S&P 500 and offers a maximum return that is some percentage of that index. Indexed annuities generally offer a minimum level of return as well.
Some annuities are immediate, meaning that annuity payments can begin immediately after the premium is paid. Others are deferred annuities, meaning that payments begin at some point in the future, as stipulated in the annuity contract.
Advantages of annuities
1. Regular payments
In an era when employer pensions have gone by the wayside, annuities can offer contract holders the opportunity to receive regular monthly payments if they choose to annuitize. These payments can provide regular, dependable income through retirement. Here’s how an annuity compares to an IRA.
2. Lifetime income
Annuities offer the opportunity not only for regular payments, but for income that may be guaranteed for your lifetime, depending on how you structure the annuity. This can be a powerful retirement planning tool and can help with planning around your other retirement investments and income sources, helping ensure that you don’t outlive your income.
3. Tax-deferred growth
Money inside of an annuity grows tax-deferred. Gains on the amount of premium invested in the contract grow with no taxes due until the money is withdrawn, assuming the annuity is non-qualified, meaning that it’s not held inside an IRA or other retirement account.
If money is withdrawn in lump sums, it’s considered a withdrawal of capital gains first, making it fully taxable. In contrast, only a part of regular annuitized payments are subject to tax, because a portion of the payment is considered a return of the cost basis (and so not taxable) while the remainder and the rest are taxed as capital gains.
4. Guaranteed rates of return
Some annuity contracts, typically some fixed annuities and indexed annuities, offer guaranteed rates of return. While your rate of return on these annuities can be higher than the minimum, it’s nice to know there is a floor on the rate of return, too. However, sometimes this floor can be a loss instead of a gain.
5. Survivor options
Annuity contracts offer several options for survivors of the contract holder, though they vary from insurer to insurer. The contracts will typically offer an option to designate beneficiaries in the event of the account holder’s death.
In addition, annuities may offer options that allow survivors to continue to receive payments upon the annuitant’s death. This might be a joint and survivor option for a spouse or a “period certain” option for a non-spousal beneficiary.
Disadvantages of annuities
1. High expenses
One of the knocks on many annuities are the high expenses of the contracts. Expenses erode the owner’s returns, especially on a variable annuity where the value depends on the investment returns. Some annuity contracts are so complex that the full rate of the internal expenses is hard for the average investor to ascertain and understand.
2. Difficult to exit
While it may be possible to get out of an annuity contract, it may not come cheap. Some insurers make it difficult to exit an annuity by imposing high surrender charges. These charges might amount to 10 percent or more of the value of the contract in some cases. Typically, the surrender charge will decline over time.
And you’re not able to get out of the contract whenever you want, since annuities typically have a limited surrender period. These periods can vary and sometimes are as high as 15 years, but it depends on the contract.
3. Possibility of an insurer defaulting
Annuities are guaranteed by the insurance company that issues the contract. While there have not been a lot of defaults on annuities, it can still happen. The backup to the insurance company is your state’s guaranty association. It is a good practice to check on the financial solvency of an insurer before investing in any annuity contract.
4. Highly complex
The contractual language in an annuity is complex, making it difficult for the average person to understand what their rights and responsibilities are and what they’re getting for their money. Annuities can differ markedly from one another, making it difficult to compare them.
Worse, because sales people earn a commission by selling annuities, they are not incentivized to highlight all the fine print on risks to potential buyers.
Bottom line
Annuities come in many varieties and offer owners a way to provide a guaranteed stream of income for a specified period or for life. They are another way to invest on a tax-deferred basis for those who have maxed out other retirement plan options. Despite some advantages, many annuities carry obscenely high expenses and surrender charges, in addition to being tremendously complex.