Annuities can be a reliable source of income during retirement. That much you know. But it’s everything else you may hear or don’t hear about annuities that have left you confused, wondering if annuities are a good investment.
Depending on who you talk to, you may hear completely contrary opinions. Most insurance agents will lift up annuities to make you think they are the greatest thing since sliced bread. But others say it’s just a good way for insurance agents to make some quick bucks.
What’s the deal on annuities? This post will answer everything you need to know about annuities, including if they’re a good investment decision.
What Is an Annuity?
Like an insurance policy, an annuity is a contract between you and an insurance company that can be customized to meet your specific needs. They can work as insurance against outliving your savings because they are payments that can be paid out anywhere from 10 years to the remainder of your life. If set up to do so, annuities can be paid throughout your life and beyond because the payments are based on your life expectancy.
Most people view annuities as a form of investment, but they’re contracts that lock you and the insurance company into contractual obligations. Annuities became popular during the Great Depression when most retiring Americans were worried about their retirement funds. With pension plans becoming less common with most jobs these days, annuities are still a popular option as people consider reliable income streams during retirement.
How Do Annuities Work?
Annuities, like insurance policies, transfer risk from the owner to the insurance company. You can fund an annuity through a single lump sum or a series of payments. You can rollover funds from your existing IRA or other retirement accounts. Even with doing that, you have the option to add to it over time.
The time when you’re paying toward the annuity is called the accumulation phase. According to the type of annuity you have, the accumulation phase lasts for a specified period. After that period is up, you enter the payout phase. During the payout phase, the annuity pays you. Again, the frequency of payouts depends on the type of annuity you purchase.
Types of Annuities
There are five types of annuities: immediate, deferred, fixed, variable, fixed indexed.
- Immediate Annuity: An immediate annuity is converted to an income stream for the beneficiary immediately. That means that after the initial single lump-sum payment, the beneficiary will begin receiving annuity payouts anywhere from 30 days to a year later. When purchasing the annuity, the owner chooses how often the payments will come.
- Deferred Annuity: A deferred annuity starts paying the beneficiary at a future date. That could be years or decades in the future. As the owner makes regular payments to the annuity, the premiums grow tax-deferred inside the annuity, with added tax advantages as well as lifelong income. This type of annuity provides a future stream of income without tax restrictions. They’re held in retirement and non-retirement accounts and work as an immediate annuity, except payments begin 13 months to 40 years in the future.
- Fixed Annuity: With a fixed annuity, the owner sets it up so that the annuity pays out a guaranteed minimum rate of return and/or a fixed series of payments to the owner or beneficiary. When the annuity is in its accumulation phase, the insurance company invests the premiums in high-quality, fixed-income investments, like bonds, and guarantees a rate over a fixed period.
- Variable Annuity: While fixed annuities are invested in bonds, variable annuities are invested in subaccounts, like mutual funds. Thus, the rate of return is based on the performance of those subaccounts. With the fixed annuity, the insurance bears the risk, however, with the variable annuity, the owner bears the risks. Most times, the owner has the opportunity for higher returns than with the fixed annuity, but there is no guarantee.
- Fixed-Indexed Annuity: With a fixed-indexed annuity, the annuity has a minimum guaranteed rate of return with total returns based on an underlying index like the S&P 500. This type annuity will protect from downside loss unlike the variable annuity. However it has the opportunity to earn more interest than a fixed annuity. The difference is the fixed-index annuity will cap or limit your earnings in order to guarantee no market loss. Typically there are no fees to own a Fixed-Index annuity unless you choose to add additional benefits.
Early Withdrawal Penalties
According to the contract set between the owner of the annuity and the insurance company, the payouts will not start before a certain period. Should the owner decide to withdraw funds from the annuity before that time, there is a penalty to pay, called surrender charges.
Surrender periods can vary from two to 10 or more years, and the surrender charge declines the longer the annuity is in the accumulation phase. So, while a surrender charge may be 10% the first year, that penalty will begin to slightly decline each year.
Also, just as with most retirement accounts, earnings withdrawn before age 59 ½ may be subject to a 10% federal tax penalty.
How Are Annuities Taxed?
Annuities are tax-deferred, which means you don’t have to pay taxes while it’s accumulating. As with other retirement accounts, you pay taxes when the money is withdrawn. If your annuity is accumulated using pre-tax dollars (qualified annuity), everything withdrawn will be taxed at your ordinary-income rate. However, if your annuity is accumulated using after-tax dollars (non-qualified annuity), you won’t be taxed on the portion of your withdrawal that represents a return of your original principal. Only your earnings will be taxed.
Most annuities have no annual fees but not variable annuities. Variable annuities often have annual fees anywhere from 2.5%-3%. All annuities have commissions that are built into the policy. Commissions can be anywhere from 1%-10%, depending on the type of annuity. Most of the Fixed and Fixed-indexed annuity commissions are paid by the insurance company not out your account or principle
Since the costs are built into your policy, it would be to your advantage to know these costs. You can know by asking your agent or representative what the commission is for the annuity. Remember, the commission is there even if you don’t see it on paper.
Pros and Cons of Annuities
If you’re wondering if annuities are a good investment, here are the pros and cons.
- Guaranteed Income: An annuity is a contract between the owner and the insurance company. One of the aspects of that contract is guaranteed income to be paid out at a certain period by the insurance company, regardless of how long the beneficiary lives.
- Customizable: Annuity contracts can be customized to the needs of the owner. That may include additional provisions and riders as needed.
- High Commissions/Fees: In some cases, the commission will be higher for annuities than mutual funds. And while the fees and commission may not always be obvious on the contract, they do exist. It’s important for the owner to ask specific questions about commissions and fees upfront.
- Other Fees/Penalties: Annuity contracts also impose higher maintenance and operation charges than mutual funds. Should you decide to withdraw all of your annuity before a certain period, you will endure surrender charges.
Are Annuities a Good Investment?
Annuities can be a good investment if you’re looking to have a reliable source of income during retirement. If the annuity is set up as such, the beneficiary could receive income for the remainder of their life. Also, if you are looking for a place to limit the massive up and downswings of the market.
Annuity costs, such as the commission, fees, and penalties, should be considered before purchasing. Make sure to ask the right questions so you know exactly how much fees and commissions will be. The purpose of the annuity is to have a stream of income during retirement. Avoid withdrawing early. Not only will it save you from having to pay unwanted penalties, but it will also guarantee your money is there for life.
The insurance company is responsible for paying out the annuity. However, that commitment is only as good as the company behind the annuity. Make sure to only do business with reputable companies that receive high ratings for their financial strength.
Lastly, always take advantage of the free look period. The free look period is the time (10-31 days) an owner can review their contract to decide if the annuity is in their best interest. During the free look period, if you decide to cancel, you get a full refund. Free look periods do vary by state, so be sure to inquire about the free look period in your state.
Need help or have more questions about annuities? Schedule a time to speak with an annuity pro.