Annuities are bought to avoid the risk of outliving retirement savings. In many ways, annuities are more like insurance products than investment vehicles, just in reverse. When we buy insurance, we pay a small monthly premium to protect ourselves against a big, unexpected expense in the future. When we buy annuities, we make payments upfront—known as the “surrender” or “accumulation” period—in exchange for a steady income stream later. Annuities aren’t for everyone and can be complex products in their own right. So, today, we’ll break down the advantages and disadvantages of annuities and discuss who they work best for.
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
How Do Annuities Work?
Annuities come in many shapes and sizes, but the philosophy behind the product remains relatively static. By purchasing an annuity, we’re guaranteeing a series of payments in the future—sometimes for life. A good way to think of annuities is as insurance against running out of money in retirement. In fact, most of the time, you’ll be buying an annuity from an insurance provider, not an investment broker.
Annuities come in several different packages, but most can be broken down into three specific groups:
- Fixed Annuities. A fixed annuity guarantees a steady rate of return over a selected length of time. There’s no market risk involved with fixed annuities and the payouts are set. The purchaser of a fixed annuity often wishes to guarantee a life-long income stream without risking money in the financial markets.
- Variable Annuities. On the other hand, variable annuities can be sold to investment firms, where products like mutual funds can be added to the portfolio. A variable annuity doesn’t have a set rate of return and can be much more profitable than a fixed annuity if the market marches higher. However, variable annuities do come with investment risk, and you could potentially lose part of your principle.
- Fixed Indexed Annuities. These are hybrid products, taking on some characteristics of both fixed and variable annuities. Growth is tied to a stock index like the S&P 500, which gives some potential for increased payments but also protects against the downside risk of variable annuities. Indexed annuities offer access to potential market returns without actually putting any principal at risk.
Annuities can be immediate or deferred. An immediate annuity will begin issuing payments right away, usually because the buyer purchased the contract using a lump sum. A deferred annuity means payments are made by the buyer in order to build up the principal (the accumulation stage) until a certain level is reached. Once the accumulation stage ends, the product is “annuitized” and monthly payments to the original buyer begin.
Advantages of Annuities
Here are some advantages of annuities:
- Lifetime Payments. Buyers of annuities often fear running out of cash before they die and wish to lock in a steady income stream. By securing a lifetime string of payments, annuity buyers gain peace of mind over financial matters.
- Lack of Risk. Fixed annuities do not expose any principal to market risk, so buyers don’t need to worry about losing money. Indexed annuities also have protections from market risk in place. Plus, some variable annuities can be adjusted to limited downside risk. Annuities are considered one of the safest forms of retirement saving.
- Purchasing Options. Annuities are sold by many different financial institutions, including insurance companies, brokerage firms, and banks. This makes it easier to find a product with an institution you have a pre-existing relationship with.
Disadvantages of Annuities
Here are some disadvantages of annuities:
- Limited Upside. Annuities take risk off the table, but even variable options often fail to match the returns provided by a portfolio of stocks and bonds. If you’re young and have room to survive a recession, an annuity probably shouldn’t be your first choice.
- Fees and Commissions. Beware of the fine print when it comes to annuities. Unlike retirement vehicles like 401(k) and IRA plans, annuities are often loaded with different fees and commissions, all of which eat into your returns.
- Early Withdrawal Penalties. Just like other retirement savings vehicles, you’ll need to lock up your money for an extended period of time. But unlike tax-deferred investment accounts, you won’t reap the benefits of market returns in exchange for locking up your cash. Taxes and a 10% withdrawal fee may be issued if you seek to take money out before you’re eligible.
Who Are Annuities Best Suited For?
Annuities aren’t for everyone. If you’re young or not averse to risk, an annuity likely doesn’t make much sense. Remember, these products are more like insurance than investments, so if your time horizon is long enough, choose a market-based vehicle. However, an annuity is still an excellent choice for some people. Maybe you’ve maxed out your 401(k) and IRA and wish to spread out some savings into other areas. Or, you could simply be a conservative saver who can’t stomach the volatility of capital markets. Either way, be sure to consult a financial advisor before buying any investment product, especially one that requires money to be tied up like an annuity.
Work With an Experienced Financial Advisor
We hope you understand the advantages and disadvantages of annuities. If you’d like to learn more, consult with a team member from Good Life Financial Advisors of Mount Pleasant today!
Equity Indexed Annuity – Equity Indexed Annuities (EIAs) are not suitable for all investors. EIAs permit investors to participate in only a stated percentage of an increase in an index (participation rate) and may impose a maximum annual account value percentage increase. EIAs typically do not allow for participation in dividends accumulated on the securities represented by the index. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Withdrawals prior to 59 ½ may result in an IRS penalty, and surrender charges may apply. Guarantees are based on the claims paying ability of the issuing insurance company.
Fixed and Variable Annuities – Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.