If you’re approaching retirement, you’re probably worrying about the balances in your retirement accounts.
You’re not alone.
Nearly 50% of Americans are worried that they don’t have enough retirement savings.
Having a good retirement plan with stable income can be the difference between a comfortable retirement and one full of uncertainty.
There are many ways to plan for retirement so you can have peace of mind and financial stability.
Today we’re looking at one option retirees can use to generate income during retirement: annuities.
Annuities are complicated, and many people don’t understand the potential downsides.
This article will answer some of the most common questions regarding annuities. Like how do they provide steady retirement income? How are annuities used? What are the downsides of annuities?
So before you go out and purchase an annuity, check out this guide to determine if an annuity is the right tool for your financial plan.
What Is An Annuity?
An annuity is a contract that an individual makes with an insurance company that ensures an individual receives a fixed sum of money, usually for the rest of their life. The individual pays a certain amount of money into the annuity. In return, the insurance company pays the individual in installments for the remainder of their life.
Many retirees find it difficult to live on social security and savings alone, and annuities offer lifetime income for policyholders. And unlike other investment products, annuities are more stable, making them attractive to people with low risk tolerance.
Annuities come in many forms and have many variations.
In some cases, you can pay one lump sum into an annuity and start receiving monthly or yearly payouts as early as 30 days later.
In other cases, you can pay into the annuity for a certain period of time, and once you have paid X amount of dollars, the annuity will start paying you.
With an annuity, you will get a certain amount back regularly for a period of time (it can be the duration of your life if you so choose). There are two main types of annuity payments to consider: fixed payments and variable payments.
We’ll get into the various types of annuities later on.
How Do Annuities Work?
The accumulation phase is the period in which you pay into the annuity. You can make a large payment in one lump sum, or you can choose to make a series of payments.
As soon as you have made all of the agreed-upon payments into the fund, the accumulation phase will end, and the payout phase will begin.
You can establish your annuity so that you receive payouts until the time of your death or some other agreed upon time. What makes them so popular is that it’s a guaranteed way to ensure that you have a steady stream of income, no matter how long you live.
But how much can you actually earn?
That all depends on your life expectancy and how much you put into the initial investment. The longer your insurance company expects you to live, the lower your monthly payments will be.
You can structure an annuity to pay you for life with a “period certain” payout. For example, let’s say that the “period certain” payout covers you for 20 years of payments. If you die in 15 years, the remaining payouts (for those remaining 5 years) can be paid to a beneficiary or heir. In some cases, the insurance company will profit and keep that money.
It all depends on the type, structure, and terms of your annuity.
Many retirees fund their retirement with a combination of an annuity, social security, and other savings. So it’s important to decide how much you want to invest and how long you want the payout period to be before you sign any contracts.
Different Types of Annuities
There are three main types of annuities. You’ll need to think about your long-term plans and consider what other sources of income you have in order to decide which one is right for you.
With an immediate annuity, as soon as you finish the accumulation phase, you are eligible to start receiving payments. To speed up the process, you can make a lump sum payment into the annuity. Depending on the insurance company you choose, you can begin receiving payouts in as little as 30 days.
With a deferred annuity, you’ll receive payments at a later date – a date that you agree to when you make your initial investment. Again, you can make a lump payment or make a series of premium payments into the annuity through the accumulation phase.
An indexed annuity offers you the chance to enjoy higher yields based on stock market performance. It also protects you against stock market declines. It is much more complicated than a standard fixed annuity, and it has market caps and fee-related deductions.
Regardless of whether your annuity is immediate or deferred, you also have options of what type of payouts you want:
With a fixed payout, you’ll receive the same amount every month or every year. This amount will be determined up front, and as long as you receive payouts, it will never change.
A variable payout varies from month to month and year to year. When you invest in an annuity, the insurance company invests your money into other sources. Depending on how the insurance company’s underlying investments perform will determine how much you get paid each month or year.
The variable annuity offers the option to provide you with more than what you invested up front, but it doesn’t usually yield that much. You’ll have to decide for yourself if it’s worth the reward or if you prefer a steady, fixed payment that never changes.
Keep in mind, you’ll pay higher annual fees to have a variable annuity. In some cases, the fees can cancel out the benefits of the variable payout.
What Are the Benefits of Annuities?
The stock market can be volatile, and investments in the market are subject to high growth as well as significant loss. Unlike stock market investments, annuities are secure and not subject to market fluctuation. This makes annuities a good option if you are looking for a guaranteed steady stream of income for the rest of your life.
In addition to the limited investment risk, any money you invest in an annuity grows tax-deferred, meaning the amount you contribute to the annuity is not taxed. But when you start receiving your withdrawal benefit, the payments you receive will be subject to ordinary income tax.
An annuity is also a good option for someone who wants to make significant contributions. Contributions to IRAs and 401ks have limitations, but the limitations on annuities vary. The amounts range from about $500,000 to about $3 million. This makes it an attractive option, especially if you decide to choose a deferred annuity.
With a deferred annuity, the premiums you pay will continue to grow tax-deferred. And you can pay into it tax-deferred (up to the amount your insurance company allows).
The biggest benefit of an annuity is knowing that you’ll have a steady income stream. If your 401k plan or IRA can’t cover you through your retirement, you could end up with nothing more than your social security payouts. Annuity payouts are a great way to supplement your income and ensure a more comfortable retirement.
Annuity Pitfalls to Avoid
While there are some benefits to annuities, they come with their fair share of disadvantages as well. Many financial experts try to steer their clients away from annuities.
Here are some of the reasons why:
Annuity Contracts are Difficult to Get Out Of
Annuities are binding contracts between you and an insurance company. By investing your money into an annuity, you can feel like you’re getting a “paycheck” throughout your retirement.
But remember, the money you’re getting is your own money to begin with. The insurance company is simply paying it back to you.
Investments are riskier, but you’ll (typically) make more with traditional mutual funds than you will with an annuity. With a fixed index annuity, you can enjoy some upside, but it’s usually only about 4% a year. If you invest your money in stocks instead, you could see potential gains of 10% or more, but there’s also the chance you’ll lose money.
Basically, with an annuity, you’re trading “upside potential for downside protection.”
Annuities Have Steep Commissions and Fees
The commission rate for annuities is high – usually about 7-10% of the total amount of your investment. That makes them favorable for brokers to sell but unfavorable for the individual investor.
Depending on the type of annuity you have you can also expect to pay some annual fees. If you’re under the age of 59 ½ and need to make a withdrawal on your annuity, it will be considered an “early withdrawal.” And with an early withdrawal, you can expect to pay a 10% penalty, as you would with a traditional 401k or IRA.
Annuities tie your money up with little option to get it out. If you’re concerned about having liquid assets, annuities are not for you.
If you need to pull money out of your annuity early, you’re not going to be too happy. The “surrender” charge for an annuity depends on when you want to pull your money out. In the first year, you can expect your surrender penalty to be at least 7% of your total account value. After that first year, it drops about one point each year until you get to about year 7 or 8.
The problem is this:
Financial, medical, and personal situations change. If you need a large lump sum of money within the first year or two of your annuity, you’re going to get hit hard with fees. The 7% we mentioned above is only an average – some annuities have a surrender charge as high as 20%.
Annuities Don’t Account for Inflation
Annuities don’t account for inflation – if you have a fixed payout, you’ll get that same rate forever, regardless of inflation rates.
If You Die Young, You Can Lose Big
The insurance companies are banking on you to die before they pay out all of your initial investment. We mentioned earlier that you could leave your annuity to a beneficiary or heir – but it will cost you to do so. Before signing your name on the dotted line, make sure you know exactly what the terms of your annuity are.
As with any type of investment, annuities have their pros and cons. The most obvious benefit to an annuity is the safety of the investment. You won’t lose your money. You’ll be guaranteed a steady stream of income for years to come (or until you die). So if you’re a retiree looking for guaranteed security, an annuity might be the right choice for you.
Unfortunately, the downsides are greater.
Investing your money in mutual funds could be considered riskier, but in the long run, the stock market has a much higher rate of return. Personal investments also have the benefit of liquidity. If you need the money, you can sell your shares and have money in your bank account in a matter of days.
And if your medical situation changes drastically, you might wish you had access to that large lump sum of money sooner rather than later. And there’s no question about it – paying for medical care is one of the greatest concerns for retirees and elderly individuals.
IRAs, 401ks, and annuities aren’t the only options out there for retirees to consider.
Before you invest in an annuity, do your research to make sure that it’s the right choice for you. If you do decide to go this route, contact your life insurance company and financial adviser to learn more.