Planning for your retirement is not easy. There are a number of retirement saving options, like a 401(k) through your employer, individual retirement accounts (IRAs), and annuities.
If you're not entirely sure what an annuity is or how it works, you are not alone. While an annuity can provide a steady income stream during retirement, it also comes with a variety of pitfalls and rules that can be a little complicated to understand.
Let's start with the basics.
Annuities are instruments issued by insurance companies that pay a stream of income for a specified period. Depending on the guarantee, that period can be more immediate or into the future.
In the simplest terms, an annuity is a contract between an individual and an insurance company. The purchaser contributes a sum of money — either in one lump sum or in a series of premiums over time — to an insurance company. In return, the insurer promises to pay them a regular stream of income.
The payments can be structured to last for a specified number of years, such as 10 or 20, or the rest of the annuity owner's life — no matter how long you live.
Each insurance company has its own stipulations about its annuities, but the majority of annuity contracts are highly customizable, which may be why some say that annuities are confusing. Numerous riders are available, each offering different features and increasing the complexity of the annuity and the cost.
Some annuities are immediate, meaning the annuity payment can start immediately after the premium is paid. These are known as an immediate annuity, a single-premium annuity (SPIA), or an income annuity.
Opposingly, a deferred annuity begins at some point in the future, generally during retirement, as stipulated in the contract. There are three basic types of deferred annuities:
Like other products, annuities can be a tool in your retirement planning strategy, offering reliable income and tax advantages. However, as with financial products, they have advantages and disadvantages.
Learning more about these can help you make an informed decision about whether an annuity is right for your retirement plan strategy.
1. Lifetime income: One of the primary advantages of annuities is that they can be structured to provide a guaranteed stream of income for life, helping to mitigate the risk of outliving your savings.
2. Protection against longevity risk: While it is impossible to predict one's actual life expectancy, the anxiety of running out of money in retirement is a real concern for many Americans. Remember that you may need to purchase a rider to secure a lifetime of guaranteed income.
3. Diversification: Annuities can add diversification to a retirement portfolio, offering a source of income that is not directly tied to market fluctuations (i.e., stock market downturns).
4. Tax deferral: The growth of your annuity investment is tax-deferred until you start receiving payments. This can be advantageous for individuals looking to minimize their current tax liability.
5. Customization: Annuities often come with various options and riders, allowing you to tailor the product to your specific needs and preferences.
1. Complexity: Annuities can be complex financial products, and understanding their terms, fees, and conditions can be challenging. It's crucial to carefully read and comprehend the contract before purchasing.
2. Fees and expenses: Annuities can have high fees and expenses, including sales charges, administrative fees, and mortality and expense fees. These costs can erode the overall returns of the annuity.
3. Lack of liquidity: Annuities are generally less liquid than other investment options, and withdrawing funds before a certain age may result in surrender charges and penalties.
4. Possibility of insurer defaulting: The insurance company guarantees the annuity contract. While not common, an insurer can still default on their annuities. It is a good practice to check up on an insurer's financial solvency before deciding to invest in an annuity contract.
5. Potential for better returns elsewhere: Depending on your risk tolerance and investment goals, you may find other investment options offering better returns than certain types of annuities.
Keep in mind that creating a retirement planning strategy first before purchasing an annuity will help you know if an annuity is a good option for you before you sign any contracts. If you decide to purchase an annuity, ensure you understand all of the contract details and evaluate all the potential fees.
Also, note that the money invested in an annuity grows tax-deferred, meaning you are taxed upon withdrawal. When the owner of the annuity dies, money remaining in the account can belong to the insurance company unless specified in the contract or a rider.
Annuities are a way to supplement your income during retirement. Just like other types of saving or investment vehicles, there are positives and negatives.
If you want the peace of mind of having a guaranteed stream of income that can last through retirement, annuities may be a good option. If you are looking for a more flexible way to invest, you may be better off choosing a different type of product that is less complex and has fewer fees associated with it.
Either way, be sure to do your homework to understand better the annuity contract's terms and conditions, especially your monthly payout, and determine your risk tolerance in retirement versus when you are employed.
Seem daunting? Consider working with one of our financial planners. They can help you develop a retirement planning strategy and determine if an annuity is right for you.
David Belinkie, CFP® is a Partner and Financial Planner with Spaugh Dameron Tenny, LLC. For David, the client relationship grows even deeper when the financial plan is put into action. He feels very strongly about educating clients so that they have all the information they need to make suitable decisions for their specific situation.
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