An annuity is a contract issued by an insurance company that pays an individual a stream of income for a specified period or for the remaining life of the contract holder.
Annuities are often pushed by insurance agents and registered representatives as an excellent way to provide income for their client’s retirement needs. Annuities have several pros and cons to consider before investing your retirement funds there.
How an annuity works
There are several varieties of annuities, but they all have some sort of underlying investment vehicle. The money in an annuity grows tax deferred. Annuities can provide income for life, or the money can be taken out as a lump sum either all at once or at various points in time.
Annuities are either purchased through a single premium payment or several payments over time.
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 used.
- Fixed annuities. This type of 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.
Note, some annuities are immediate, meaning that annuity payments can begin immediately. Others are deferred, meaning that payments would begin at some point in the future.
Advantages of annuities
1. Regular payments
In an era when employer pensions are going 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. This can be a powerful retirement planning tool and can help with planning around your other retirement investments and income sources.
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 Gains on the amount of premium invested in the contract grow with no taxes due until the money is withdrawn, assuming the annuity is non-qualified (not held inside an IRA or other retirement account).
Lump-sum withdrawals are considered to be withdrawals of gains first and this amount will be fully taxable. Taxes on annuitized payments are subject to an exclusion ratio in which a portion of the payment is considered a return of the basis in the contract and the rest as gains which are taxed.
4. Guaranteed rates of return
Some annuity contracts offer guaranteed rates of return. This is common for some fixed annuities and for indexed annuities. While your rate of return can of course be higher, it’s nice to know there is a floor on the rate of return. Sometimes this floor can be a loss versus a gain.
5. Survivor options
Annuity contracts offer several options for survivors of the contract holder. These will vary a bit from insurer to insurer. The contracts will typically offer a beneficiary option to designate beneficiaries in the event of the account holder’s death.
There are also a number of annuitization 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 on the contracts. This serves to erode the returns, especially on a variable annuity where the value is dependent on the investment returns in the contract’s sub-accounts. Some 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
Some insurers make it difficult to exit an annuity contract by imposing high surrender charges. These might amount to 10 percent or more of the value of the contract in some cases. There is typically a surrender period. These can vary and sometimes are as high as 15 years. Typically, the surrender charge will decline over time.
3. Possibility of an insurer defaulting
Annuities are guaranteed by the insurance company who issues the contract. While there have not been a lot of defaults on annuities, this can happen. The backup to the insurance company is the guaranty association in your state. It is a good practice to check on the financial solvency of an insurer before investing in any annuity contract.
Bottom line
Annuities come in several varieties and can offer contract holders 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. Annuities can provide another reliable retirement income stream in this age of vanishing employer pensions.
Annuities can be problematic as well. Many contracts carry obscenely high expenses and surrender charges can make it difficult to get out of a contract if you find a better deal.
Be attentive when looking at an annuity contract. Don’t take the annuity salesperson’s word for it. Make sure to do your own due diligence.
