The Basics: Retirement Annuities

Retirement annuities may be the best investment product that generates more reactions than any other. These products are based on the principle of guaranteed income for life. But critics quickly point out that these products have many drawbacks. Not least, their high price compared to other investment options. Everyone wants the best performing retirement annuity, but it is important to fully understand the pros as well as the cons before signing any contract.

Before we discuss the benefits and drawbacks of annuities it is important to realize that not all are created equal. There seem to be an endless supply of them, but these days there are only four choices. These options are based on the two listed below.

Fixed vs. Variable Retirement Annuities

An individual can buy a retirement annuity with either one lump-sum payment or several payments. A fixed product allows you to know what you will get once the annuitization period begins. That is when the insurer begins paying you back. This is because the rate at which you will earn a return is set for a certain number of years or for your entire life. This rate is usually in the same ballpark as what a certificate-of-deposit (CD) would pay. They tend to be conservative. Other fixed annuities known as income annuities (deferred, immediate) can offer rates that are substantially higher than CD and most bond coupon rate rates. They also have greater safety than bonds.

Variable annuities work in a different way. Your return will be based on the performance a selection of stock and bond products (subaccounts). Although there are more opportunities for growth than an fixed annuity, there is also greater risk. An insurer might allow you to purchase a riders that will guarantee a minimum withdrawal regardless of market conditions.

Comparison of immediate vs. Deferred Retirement Annuities

You pay the insurer a lump amount and you start receiving regular payments with an immediate annuity. For example, an older adult might choose to place some of their nest eggs into an annuity to receive a steady income stream.

A deferred product is, however, more of an investment tool. You won’t receive your funds until you have paid in. You have the option to earn interest (fixed and variable annuities), as well as benefit from market gains (variable or fixed annuities) before you reach that date.

Annuities: What are the Pros and What Are The Cons?

There are many factors to consider when discussing the pros and disadvantages of annuities.

Pros

Annuities can be appealing for many reasons.

Income for Life – Perhaps the most compelling argument for annuity is that you get income for life. However, some annuities only pay out for a limited time. This isn’t always true with traditional investments, especially if your nest egg doesn’t exceed a certain amount. Annuities are a great option for people with lower incomes. They can supplement Social Security, even if they live very long.

Deferred Distributions–Another nice perk of annuities is their tax-deferred status. Similar to CDs, annuities are subject to Uncle Sam’s tax-deferred status. Annuities don’t have to be paid any taxes until the funds are withdrawn. Owners have some control over when and how much tax they pay. You can reduce your Social Security taxes by leaving money in a deferred Annuity. This is because you have less income that is taxable if you delay withdrawing.

Guaranteed Rates – Variable annuities’ payouts are subject to market conditions, while fixed annuities give you a guaranteed rate of return over a specified period. It may be an alternative to investing in stocks or corporate bonds for seniors who are looking for a reliable income stream.

Cons

Critics mention the following issues regarding annuities

Hefty Fees – Annuities are expensive compared to mutual funds and CDs. Many annuities are sold by agents who charge a significant upfront sales fee. The best way to avoid paying a large upfront fee is to directly sell products.

However, even then, there could be significant annual expenses, many times exceeding 2%. This would be high even for an actively managed mutual funds. To increase your coverage, you will pay more if special riders are added.

The lack of liquidity is another worry. You will be charged a surrender charge if your annuity is not redeemed within the first year of your contract. The surrender period usually lasts from six to eight years. Sometimes, however, they may be longer. These fees can be very high so it’s difficult to get out of a contract after signing.

Higher Tax Rates–Insurers often point out the tax-deferred status you have for your investment and interest income as a major selling point. If you take out any returns, they are treated as ordinary income. Your tax bracket may make this higher or lower than the capital gains rate.5 You might be better off maximizing your 401k plan or individual retirement account before you invest in a variable annuity.

Complexity – One of the most important rules for investing is to not buy a product that you don’t fully understand. Annuities don’t seem to be an exception. Over the past few decades, there have been many variations of annuities. Some, like the equity index annuity, have so many fees and limitations that it’s difficult for investors to fully comprehend what they are getting into.