Many Americans will be approached about buying an annuity at some point in their lives. Are annuities a good investment? The answer depends on your financial situation and the type of annuity. However, great care should be taken before buying an annuity. Annuities are aggressively pushed and oversold due largely to the lucrative commissions that advisors receive when selling them.
What is an annuity?
Annuities are perhaps the most misunderstood investment vehicle. An annuity is a financial product offered by an insurance company that provides a stream of income in exchange for a lump sum payment. The income stream can last over one’s lifetime or for a certain period of time. Annuities were designed to provide a reliable source of cash flow for retired individuals.
Types of annuities
While the definition sounds simple enough, it’s a bit more complicated. The income can start immediately or at some point in the future (immediate vs. deferred annuities). In some cases, it doesn’t start at all. There are annuities that pay a fixed rate of interest and fixed payments, and annuities that invest in the stock market and offer variable returns and income streams (fixed vs. variable annuities). There are also “hybrid” types that allow investors to participate in gains when the market rises, but guards against losses in down markets (indexed annuities). In addition to the various types, annuities offer different “riders” which offer various living benefits and death benefits.
Advantages of annuities
An annuity provides “longevity insurance” through an income stream that you cannot outlive. It can also help investors manage their money. The Treasury Department has encouraged annuity options in 401(k) plans to help ensure retirees have a stream of regular income throughout retirement.
Another possible advantage is tax-deferred growth in the annuity. This can be especially helpful for high income earners who have already maxed out other tax-deferred investments, such as 401(k) plans. However, the tax-deferred growth is not always an advantage. For example, some investors might be better off paying a lower capital gains tax rate on their investments than to pay higher ordinary income tax rates when they eventually take withdrawals.
Disadvantages of annuities
Annuities are very expensive. High fees mean low overall returns for the investor. A few years ago, annuity fees were more reasonable, but the costs have gone up considerably. On variable annuities with living benefit riders, it is common to see fees in the 3 to 4% per year range. Growing your investment can be very difficult to do if you need to earn 4% just to cover the fees.
If your investments are not growing due to the high fees, the insurance company is simply giving you back your own money when you start taking payments from the annuity. For example, if you put $100,000 in an annuity which guarantees a 5% withdrawal rate ($5,000 per year) for the rest of your life, you are merely taking back your own money for the first 20 years (20 X $5,000 = $100,000). You would need to live past the 20 years in order to earn a return on your money.
Another big disadvantage of annuities is a lack of liquidity. This means that once the annuity is purchased, it is hard to get your money back out. You are normally locked in for 7 years (or even up to 15 years) with limited access to your money outside of the income stream.
People who own annuities often don’t understand what they purchased. I often hear statements like, “My annuity is guaranteed to earn 6% interest per year without any risk.” Beware if it sounds too good to be true. Consumers cannot be blamed for their misunderstanding. Annuities are incredibly complex. While an advisor might say, “The living benefit is guaranteed to increase each year by 6%”, the client might confuse “living benefit” with “account value”. And with good reason – what is a living benefit anyway? Some unethical advisors might not explain the difference, might purposely mislead the client or might not understand it themselves.
Who should own an annuity?
Annuities are best suited for conservative investors who are willing to give up investment returns in exchange for a guaranteed income stream. However, many factors need to be considered before purchasing an annuity. Not everyone needs an annuity. Before buying one, consider getting a second opinion. Once in an annuity, it is difficult to get out. I have met many people with buyer’s remorse.
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