Do Annuities Make Good Investments? What to Consider Before Purchasing

by David@MoneyNing.com · 0 comments

Do annuities make good investments? How are they used for retirement income later in life?

What is an annuity?

An annuity is a type of retirement savings vehicle usually offered through insurance companies and, in one way or another, guarantees a steady income after you retire, whether in monthly, quarterly, or yearly pay-outs.

There are various type of annuities, including:

  • Fixed or variable
  • Deferred or immediate
  • Period certain
  • Lifetime
  • Joint/survivor

While these terms can be combined to create your own personal cocktail of retirement needs, the features which make the biggest difference are: whether or not you’ll be receiving payouts immediately or in the future, and whether you prefer a guaranteed payment amount or an amount based on stock market performance.

When people talk about annuities, they are most certainly talking about deferred annuities. It’s reported that around 90% of the annuities sold are deferred annuities instead of immediate annuities. Let’s cover that first.

How do deferred annuities differ from other investment accounts?

Deferred annuities share common traits with other retirement options, such as 401Ks and IRAs, in that they allow you to set aside money for retirement on a tax-deferred or tax-free basis.

There’s also no limit on how much money you can invest in an annuity, unlike the caps that are placed on other options.

Sounds awesome right? This is often touted as one of the key benefits of an annuity, but there are downsides on the tax front too. Annuity payments are taxed as ordinary income at ordinary income tax rates, not the preferred capital gains tax rate.

What are the advantages and disadvantages of a deferred annuity?

Deferred annuities are helpful for three reasons.

  1. If you’ve already maxed out your investment ceilings in 401Ks and IRAs, then you can put more money into policies for tax-free growth.
  2. There’s a big surrender charge, which helps many people save because they are reluctant to take money out for wasteful spending.
  3. It trivializes the need to figure out how much income to withdraw from a lump sum in retirement, which can be a major stress reliever for some people.

If you’ve already invested in a deferred annuity, you can change the terms to an immediate when you decide to start withdrawing money. Those who want a guarantee of income for a spouse or dependent after they’ve died are also attracted to annuities based on their options for guaranteed payments within a fixed year range or even for the lifetime of the survivor.

These features make them similar to life insurance in some respects.

The first bad news you’ll hear about annuities is their expense-to-benefit ratio. Annuities, or more specifically, deferred annuities, are sold by insurance companies whose agents receive up to 10% commission on annuity sales, and up to 3% yearly maintenance fees.

If you withdraw within the first 7-8 years of investing in an annuity, you’ll probably be subject to a surrender charge, similar to the early withdrawal penalties associated with 401Ks and IRAs as well.

Furthermore, if you choose a variable instead of a fixed annuity, you run the risk that the investment performance will not outpace the high fees you’ll be charged for it.

Are there alternatives to annuities?

The main advantage of annuities is their ability to provide immediate and set income throughout retirement; if you’re in the place in life where you need security and dependability, the advantages of this option may outweigh the disadvantages.

Otherwise, if you have a while to go before you retire, consider mutual or index funds — investment accounts that carry lower annual feeds and might yield more money while you don’t mind the risk.

What about Single Premium Immediate Annuity?

I know I just made annuities sound pretty bad, but not all of them are disastrous. One such option you should consider is the single premium immediate annuity (SPIA).

The gist of it is that a SPIA is a contract between the insurance company and yourself. You hand over a lump sum, and you are then guaranteed to be paid a monthly payment for life. It’s almost like getting a job, only that you are a) buying the income stream instead of performing work, b) you won’t be getting promotions and thus a big jump in income because you aren’t getting any performance reviews, and c) you are guaranteed not to be fired unless the insurance company goes under.

On the last point, the state government will take over the annuities and pay out the claims if an insurance company goes into liquidation. There’s a limit that varies by state though, so it’s best to look up that limit for your own state and spread your risks into several different companies if you are buying such a big policy that it’s going to be higher than the government guarantee.

Why would I want a SPIA?

There are a few advantages to buying a SPIA. For one, you don’t have to worry about fees because the income you are quoted is already net of fees. This means that whatever monthly payment you agree to is going to be the payment you get every month. The main benefit of a SPIA though is that you can offload your longevity risks to the insurance company just in case you are fortunate enough to live a long life. This could be a win-win for you and the insurance company because the insurance company can pool the risks from many different policyholders while you don’t really have that luxury.

What are the different options?

Immediate annuities are pretty simple but there are still a few variations you need to decide from the get-go. Do you want your spouse to be included in the policy (meaning the annuity will keep paying until the death of both spouses)? Do you want the monthly payment to be adjusted for inflation through the years? Which option will be best really depends on how long you and your significant other lives, as well as whether inflation will pick up or not. That’s one aspect an annuity cannot guarantee.

Another is whether your insurance company can go under. Many people will tell you to check the credit ratings of insurance companies and make sure you get the policy from the most financially sound institution. While you certainly want to get a policy that’s from a reputable insurance company, I’m not sure if the credit agencies will do that much good. Did anyone think AIG was going to go under? Were they not an incredibly reputable and seemingly solid company? Yet it certainly would have gone under in the financial crisis if the government hadn’t step in and taken over.

That’s why the only real way to limit your exposure is to get multiple policies from different companies if the amount under consideration is going to be higher than the state guarantee limit.

The chances of insurance companies going under are slim, but it’s not zero. This is really important, so don’t be lazy and just get whatever policy that pays the most.

Have you purchased an annuity as part of your retirement income? What was your experience?

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