When saving for retirement, many people look into annuities, insurance products that provide a steady stream of income. However, annuities are complex products and not for everyone. At its most basic level, an annuity is a product that someone invests in to get back one or multiple payments in the future. The size of the payments depends on the payment schedule—which can be monthly, quarterly, or annually—and the length of the payment period. People can opt for a fixed annuity to pay out for the rest of their lives or for a set number of years. Payout also depends on the type of annuity in which people invest. However, annuities carry high expenses, which can curb the ultimate value of the investment.
The Primary Types of Annuities
While a number of different types of annuities exist, they fall into the immediate or deferred category. An immediate annuity means that people receive payment as soon as they invest. With a deferred annuity, money is invested for a period of time before people receive payment. Usually, annuities are deferred until retirement. A deferred annuity can be converted into an immediate annuity if an investor wants to begin receiving payments earlier than planned. Within these two categories, there is another division: fixed and variable annuities. A fixed annuity pays out a predetermined sum, while a variable annuity pays out according to the performance of the market or that of the underlying investments.
The Benefits and Disadvantages of Annuities
Like many retirement investments, annuities have tax benefits. The funds invested in an annuity are allowed to grow without being subject to taxation. When people begin receiving payments, the income is taxed as normal income. Annuities have no annual contribution limit, so individuals can invest a significant amount of money for retirement without having to pay taxes on those funds. This benefit makes annuities particularly suitable for individuals close to retirement age who are worried about having enough money.
The other major benefit is the flexibility of the payment schedule. While it is possible to receive a lump sum, many people allow the fixed payments to serve as a supplement to pension plans and Social Security, particularly if they are worried about having sufficient monthly income.
The drawbacks to annuities are the many fees that can come along with them. Buyers need to research what fees are charged for this investment. Most annuities come with a commission since they are sold by brokers, and this fee can be as much as 10 percent. Some annuities have surrender charges, which are incurred if the money is pulled out too soon after investment. Surrender charges are often 7 percent in the first year, then decrease by 1 percentage point each year after until they reach zero. However, some annuities can have surrender charges of up to 20 percent. Annual fees are another concern, especially among variable annuities. These accounts can have annual insurance charges, annual investment management fees, and other expenses that can add up to 4 or 5 percent annually.
Of course, not all annuities have such high fees. Investors need to read the fine print and look for investments without surrender charges and sales commissions, often called direct-sold annuities since they do not involve insurance agents. Low-cost annuities are also available from Schwab, Vanguard, Fidelity, and other major firms.
Typical Annuity Payout Options
When investing in an annuity, individuals need to think carefully about the payout option they prefer and the implications of each choice. A certain period annuity is the most popular option. With this product, investors are guaranteed specific payments over a set period of time, usually ranging from five to 30 years. In the event of one’s death during this period, a named beneficiary will begin receiving the payments.
Lifetime payments do not have the same survivor benefit. However, they do come with the guarantee of set payments for life. In this case, payments can be variable or fixed, depending on one’s preference. While payouts are determined by life expectancy, payments stop completely upon one’s death.
Married couples often opt for joint and survivor annuities. These vehicles continue to pay out to a named survivor for the rest of his or her life after the primary beneficiary dies.
Another option is the life income with period certain annuity. Individuals are guaranteed payouts for the rest of their lives, and they also set a period certain phase. In the event of one’s death during this phase, a beneficiary continues to receive payments until the period ends.
What to Think About When Considering Annuities
While annuities can be a great vehicle for retirement investing, they are not the best option. In general, people should max out their 401(k) plans and IRAs before they turn to annuities. If these vehicles are maxed out, annuities are a great option for tax-free money growth, and they make sense for individuals in high-income tax brackets.
At the same time, people should keep in mind that annuities constrain them from touching the money for years, especially if the account has high surrender charges. Finding annuities that do not carry these high fees can be difficult. Often, fee structures are very complex and downplayed by the people selling the annuities. Investors should ask many questions and carefully review the deal before investing.