The term annuity can sound almost quaint — like the financial strategy of a little old lady in an Agatha Christie novel. And because these retirement products are sold through insurance companies, it can be somewhat difficult to understand the pros and cons of annuities in the midst of a sales pitch.
While it’s possible for a deferred fixed annuity to be a reasonable financial strategy for some modern retirees, there are plenty of downsides to be aware of.
Here’s what you need to know about deferred fixed annuities before you decide if they’re the right financial product for you.
What is an Annuity?
Annuities are products offered through insurance companies. The investor pays in a lump sum to the annuity, which then makes payments to you in the future, either monthly, quarterly, or annually. It’s important to note that deferred fixed annuities generally only allow you to withdraw up to 10% of the value of the annuity each year until you reach the end of your “surrender” period.
Fixed annuities are much like Certificates of Deposit (CDs), in that they offer a guaranteed rate of interest on your investment. In addition, fixed annuity interest rates are sometimes higher than those of CDs, since the insurance carrier will put the money in longer-term bonds, which can offer better rates of return.
Unlike CDs, however, annuities aren’t FDIC insured, which means that you could lose your money if the insurance carrier holding the annuity fails. However, purchasing an annuity through an insurer with the highest financial rating should provide you with peace of mind about the safety of your investment.
Why Choose an Annuity?
These products tend to be very attractive to individuals who’d like to have a convenient and known income stream in addition to their other retirement income. They’re considered a safe investment, which is very appealing to investors feeling gun shy about taking investment risks.
Annuities offer guaranteed minimum interest rates, so investors know that they’ll never earn less than this amount. Annuities offer death benefits, meaning that in the event of your death, your beneficiaries will receive both your original stake in the annuity and the interest you’ve earned. Investors also appreciate that they don’t need to pay tax on their interest until they withdraw it.
Lastly, annuities are popular because they allow you to treat them like an income. In that case, you’d have regular payments made to you for a specific number of years, or for as long as you’re alive.
Deferred Fixed Annuity Pitfalls
Unfortunately, despite the pros of this financial product, it’s not necessarily a smart investment. The guaranteed minimum interest rate doesn’t always stay the same from the first year forward: insurers will often offer an introductory “teaser” rate before the annuity’s guaranteed minimum drops down to something much less lucrative.
The surrender period can also cause issues for investors. There’s a hefty surrender fee for withdrawing your money prior to the end of the period, which could be as long as 10 to 15 years. In addition, withdrawing the money from your annuity prior to age 59½ will mean you owe the IRS a 10% early withdrawal fee.
The bottom line: if the interest rate after the teaser period is lower than that of inflation, you’ll see your money slowly losing its value, but you’ll be unable to rescue it.
Smart Retirement
Before you make any decisions about a deferred fixed annuity or any other retirement product, make sure you understand all of the fine print and potential pitfalls. This is one of the many reasons why you ought to work with a trusted financial adviser to help you find the best strategy for your retirement.
David’s Note: Make sure you take the time to truly understand how the financial adviser is compensated if you decide to work with one. There are many insurance agents disguised as financial advisers who will push you products that you don’t need just to get a fat commission.
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What the min. you could invest in annuity because I’m on SSA. I got hurt working 2 full time jobs. And would love to buy annuity now.
Annuity is good because it helps a man to remain financially active after retirement by providing him a regular cash flow. But annuity is a very complicated product to deal with. I think one of the major drawbacks of annuity is the high surrender fee. This fee leaves the annuitants with no control over his invested money.
Most states have a guaranty fund that will cover default on an annuity (and other insurance products) up to a limited dollar amount. Most states are around $100,000. Make sure your company is sound, has excellent financial ratings and then consider limiting your exposure to any company by splitting your annuity purchase between several companies (just as you would do if you were looking for FDIC insurance on deposits).
Like you said, it’s meant for those who would prefer a safer income stream (especially for those in the middle class). In that case, it would be great.
Just a note of advice, you should buy the annuity from a big insurance company (the small ones are better to be avoided)