How to Know If You Should Buy an Annuity

What to know before you buy an annuity

Your grandfather warned you about annuities, but what if an annuity is right for you? Here’s how to know if you should buy an annuity.

What’s an annuity?

The short answer is that an annuity is an insurance contract that gives the holder or annuitant (and their spouse if a survivor benefit is selected) guaranteed income for life.

The long answer is that an annuity is an insurance contract – not an investment – issued by a financial services firm or insurance company. It pays out invested funds, often earned interest and sometimes growth, in a fixed income stream sometime in the future. Many people buy annuities for guaranteed income for a pre-determined duration, usually for life.

Therein lies the main benefit of annuities; annuities help reduce and even eliminate income insecurity for those who need it, usually retirees.

Think of a trapeze artist in training with a safety net below them when they practice. They’re skilled but have a net below them for extra protection. Annuities are like that safety net and can protect you from outliving your income, a fear many older people live with today.

Annuities, though, are long-term strategies, not short-term strategies, and they can be part of a long-term financial plan, not necessarily the whole plan.

What types of annuities are there?

There are different types of annuities: immediate and deferred, fixed and variable, and, of course, hybrids. There are always hybrids.

Immediate annuities are funded with lump-sum payments from an inheritance, lawsuit settlement, or lottery winnings in exchange for immediate cash flow that lasts for a pre-determined term or a lifetime. Deferred annuities are usually for older investors looking for tax-deferred growth and guaranteed income by a specific date in the future and to last for a pre-determined duration or a lifetime.

Fixed annuities have fixed terms, such as fixed interest rates and payout periods. Variable annuities offer payouts of variable sizes based on the performance of an underlying portfolio of investments designed by the insurance company. Payouts are contingent on contributions during accumulation, rate of return, and fees.

Indexed annuities are a hybrid of fixed and variable annuities and are the more complex kind of annuities. Indexed annuities offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. An underlying index, for example, would be the S&P 500. An annuity indexed to the S&P 500 won’t mirror the S&P 500 but be affected by it.

What are the phases of annuities?

An annuity has two phases: the accumulation phase and the payout phase.

During the accumulation phase, the annuitant makes payments that may be split among various investment options. This payment could be a lump sum payment or recurring payment, or contributions over time

During the payout phase, the annuitant receives payments from the principal, income, and possible gains. The payout phase can last for a pre-determined duration, such as 15, 20, or 30 years, or for the annuitant’s life (or their spouse if a survivor benefit is elected).

What are the risks of buying variable and indexed annuities?

Variable and fixed annuities are designed for long-term holding. Because of the underlying index, they also carry the risk of market fluctuation, though losses can be mitigated with the right annuity rider. Finally, early payout fees and taxes are often due upon early payout.

What’s an annuity rider?

Ads for cars often display the base-model price. Car buyers then add features to their car orders, increasing the net cost. Car buyers can add as many features as they want, and the more features they add, the more their cost increases.

Such is the case with annuities and annuity riders. Annuitants can pick a “base model” fixed, variable, immediate, or deferred annuity and add riders or additional features to accommodate their needs or concerns.

Two familiar riders include a living benefit rider and a death benefit rider. A living benefit rider helps annuitants while they’re alive. Payouts track inflation and are based on the annuitant’s or the annuitant’s spouse’s age. A death benefit rider triggers when an annuitant has passed away, and the money from their annuity goes to a beneficiary to pay for funeral expenses or funds a donation or charity.

Other riders can include maximum loss protections for indexed annuities, as alluded to above, accelerated payout benefits due to a terminal illness, a cost-of-living rider pegged to inflation, or the Consumer Price Index (CPI). There are also impaired risks, commuted payouts, and long-term care riders.

How much do annuities cost?

Fees for an annuity can include but aren’t limited to:

• Administration fees
• Early withdrawal fee
• Add-on riders
• Agent fees

As the car analogy explains, the more complex an annuity contract, the more expensive the annuity.

An agent selling an annuity is paid a commission or a flat fee. Commissions are paid based on the dollar amount put into an annuity contract. A fee is paid based on the features added to the annuity contract and can range between 0% and 10%.

For example, when you get a bottle of wine at a restaurant, the cost and amount you spend will increase based on how much you decide to tip (like a commission). If you go to a liquor store, the only way your cost will increase is based on how many bottles of wine you get (like the riders you buy).

When should you consider buying an annuity?

Most folks buy an annuity primarily because they want guaranteed, predictable income. So, the main reason you might consider buying an annuity is that you are at a point where you want guaranteed, predictable income.

An annuity also offers an unlimited tax-deferral opportunity. Both company-sponsored retirement plans, such as 401(k)s, and Individual Retirement Accounts (IRAs) have contributions limits and are only available to those who have earned income each year. So, if you’ve either maxed out these two retirement plan options or you’re not currently working and still want to save money in a tax-deferred vehicle, an annuity is right for you. A bonus is that there are no withdrawal requirements; you can hold your annuity as long as you like.

Other reasons to consider buying an annuity are that the stock market’s too volatile for your risk tolerance, you want premium protection, a more specific return, or you want to know exactly how much interest you’ll earn. Finally, annuities can offset any inability to get life insurance or give you long-term care protection if you don’t want to pay for it out of pocket.

What are the risks of buying an annuity?

As with everything, annuities aren’t without risk. Below are some risks to consider before you buy an annuity.

1. Opportunity cost

Opportunity cost is the loss of potential growth you might get by putting your money elsewhere, likely in the stock market.

It’s important to remember that an annuity is not an investment, and annuitants aren’t necessarily looking for growth. Plus, opportunity costs only apply to those with higher risk tolerances. Conservative investors or those who would otherwise prefer sitting in cash aren’t affected by this risk if they can sleep better at night.

2. Purchasing power risk

Purchasing power risk is an inherent risk with annuities because the yield generated by an annuity may not keep up with inflation, making it harder to buy as much or more tomorrow as it is today. Purchasing power risk is also a risk for those who keep their money in cash, interest-bearing accounts, and low-yield money market mutual funds, yet many people still put their money in these investments.

3. Liquidity risk

Liquidity risk is the risk of being unable to easily access the money in your annuity, which is also inherent in many fixed-income products and alternative assets, including real estate.

Many annuity issuers, though, let annuitants withdraw up to a certain percentage of their cash each year without penalty. This premature withdrawal is usually capped at 10%. However, Money withdrawn prematurely from an annuity might still be taxed.

4. Surrender risk

Surrender risk is paying surrender fees on money prematurely withdrawn from an annuity. Surrender risk includes early withdrawal fees (possibly waived for withdrawals up to 10%) and taxes.

5. Market risk

Like investing in stocks, mutual funds, and ETFs, market or investment risk is the liability inherent with variable and indexed annuities, as a portion of the annuity mirrors all or a part of the stock market. Market or investment risk can be mitigated by protective riders that transfer market risks to the issuer.

6. Credit risk

Credit risk, same as with bonds and other fixed-income products, is the danger the annuity issuer will go insolvent, making it impossible for the issuer to make the agreed-upon payments to annuitants. If you’re considering buying an annuity, review the issuer’s creditworthiness with rating agencies such as AM Best, Standard & Poor’s, Moody’s and Fitch, and only buy highly rated annuities.

We’ll start and end this section by saying that annuities aren’t without risk. That said, nothing is without risk. The stock market isn’t without risk. Keeping your money in all cash isn’t without risk.

Each of us needs to educate ourselves on the risks of all the tools we consider part of our overall financial plan and balance the risks we can tolerate with the rewards we seek.

Why do people buy annuities?

People buy an annuity primarily because they want periodic payments for a specific duration or guaranteed income starting on a certain date and for the rest of their lives. Ideally, this annuity income complements income received from Social Security, retirement account investments, and other income streams. Still, it can sometimes be a solution if other sources of income are insufficient.

Another popular reason folks buy annuities is the tax-deferred growth. This is a crucial benefit for people who have already maxed out contributions or cannot access other retirement vehicles. Tax-deferred growth is an efficient way to grow retirement assets because taxes on annuity interest aren’t due until the money’s withdrawn. This lets annuitants benefit more over time from compounding interest.

Finally, many annuity holders purchase their annuity for death benefits. That means you can leave money to your heirs whether you want to leave behind a legacy or to take care of your loved ones after you’ve passed. Money left to beneficiaries on an annuity often doesn’t go through probate. Beneficiaries can receive the entire account value, principle minus withdrawals, or the account value plus accrued interest through a guaranteed death benefit.

What are the myths about annuities?

Many myths about annuities often repel people from considering an annuity, even if it would be an excellent solution for them. It’s important to separate fact from fiction to make your best decisions.

1. Annuities are bad investments

Annuities aren’t investments; they’re insurance contracts. So, comparing annuities to stocks and stock market performance is like comparing apples to oranges.

Annuities are just another tool to possibly augment your overall retirement plan and, ideally, no more. Remember, except for Social Security (which many people think won’t last) and pensions (which many people don’t have), annuities are the only product guaranteeing a stream of income you can’t outlive.

2. Annuities are risky

Let’s be honest. There’s no 100% riskless path to retirement security. There are inherent risks to investing in the stock market. There are risks to not investing in the stock market. Even CDs and bonds have inherent, though different, risks. Annuities are simply one tool in a toolbox to improve your financial security in retirement, and they are only a few tools to generate income for life.

That said, it’s possible to mitigate the risks of purchasing an annuity—the full faith and credit of the insurance company back annuities. So, you’ll want to pick an insurance company with a good credit rating by either Standard & Poor or Moody.

This might sound convoluted, but insurance companies purchase insurance from other companies. This helps reduce the insurance company’s risks and ensures that one company doesn’t carry more risk than it can withstand if something cataclysmic happens. Insurance purchased by other insurance companies is called ‘reinsurance.’ So, you’ll also want to ensure the insurance company you pick has reinsurance for your added protection.

Finally, it might be helpful to know that every state covers a minimum of $250,000 in the present value of annuity benefits, including net cash surrender and net cash withdrawal values

3. If I have an IRA, I don’t need an annuity

Annuities offer tax-deferred growth, the same as retirement accounts. So, a common objection to buying an annuity is that it’s a waste of time to consider getting it unless an investor is already maxing out contributions to company-sponsored and individual retirement accounts.

While there are benefits to maxing out annual contributions to these accounts, most people won’t have enough saved and invested in their IRAs to meet their needs, and they shouldn’t be automatically excluded from the unique benefits of annuities. Annuities offer features standard retirement accounts lack, even if annual contributions to standard retirement accounts are maxed out.

Annuities can offer a guaranteed interest rate and guarantee that you and your spouse receive guaranteed income for life. Annuities can lock in some or all the death benefits mentioned above for you and your heirs.

Finally, annuities are the only product guaranteeing an income stream you can’t outlive.

4. If I die, the insurance company keeps all my money

It is true that with some annuities if you die, the insurance company will keep your money. This is how they can cover the payouts for other annuitants—it’s how many insurance products work. But this usually only applies to life-only or immediate annuities. If this concerns you and your family, don’t buy a life-only or immediate annuity. There are other options.

What’s also true is that most annuities are designed to give a payout to your beneficiaries when you die. To ensure your heirs receive such a benefit, buy an annuity that offers beneficiary benefits.

Another consideration is purchasing a variable annuity. Variable annuities often let annuitants withdraw money early with a surrender fee, usually 10% like 401(k)s, and taxes similar to 401(k)s.

5. Annuities are expensive

Some stocks are expensive (hello Tesla! hello, Berkshire Hathaway!), and some annuities are costly, such as many variable annuities. Some annuities aren’t expensive, such as many fixed annuities. The more costly annuities have their benefits. Do your research to find out what features you need in an annuity and balance that against what you’re willing to pay for an annuity.

One way to keep your costs down is to look at only fixed annuities. Most fixed annuities have no maintenance or annual fees. Also, limit the number of riders you purchase. Adding riders increases your annuity’s overall cost and may trigger a maintenance or yearly fee. Likewise, commissions are higher for complex annuities because the selling agent must do more work.

While surrender charges can be expensive, some withdrawals have exceptions, such as for disability or long-term healthcare needs. Withdrawals are commonly free from surrender charges to cover nursing home expenses if the annuitant is diagnosed with a terminal illness or needs to satisfy IRS-imposed required minimum distributions (RMDs). It’s also good to know that surrender charges typically decrease over time.

With all that said, it’s important to remember you’re paying for:

• Guaranteed lifetime income for yourself and/or your spouse
• A means to generate income after retirement
• Principle protection
• Death benefits
• Tax-deferred growth

6. I should only consider an annuity closer to or in retirement

Look, we’ve now covered annuities on several podcasts and wrote this article because we think everyone should be open to all the financial planning tools that are available to them. Because of how annuities were created and sold in the past, too many people discount annuities without doing any research.

But today’s annuities aren’t your grandparent’s annuities. It’s also likely that your grandparents had both pensions and Social Security to support them in retirement. It’s likely, unfortunately, that you don’t have a pension. An annuity can be a substitute for a pension.

That said, immediate annuities tend to be popular with retirees, and deferred annuities are more common for saving before retirement. However, assess your wants and desires and talk with a financial planner or insurance agent about the type and structure of an annuity that may be best for you.

Finally, certain annuities can help protect your future income from market volatility, and some can help protect you against inflation. Market volatility and inflation will become more significant as you age, and you may appreciate this annuity protection.

7. It’s stupid to get an annuity when interest rates are low

Warren Buffett once said, “Stop trying to predict the direction of the stock market, the economy, or elections.” We’ll add, “Stop trying to predict where interest rates will go and what the fed will do.”

No one knows what the fed will do tomorrow, not even the fed. Plus, the fed is playing a short game; with retirement planning, you’re playing the long game.

Pro annuity tip: The free look period

Finally, knowing that most annuities offer a ten to 30-day “free look” period might be helpful. Most insurance companies or financial services firms offer prospective annuitants a period immediately after purchasing a contract when you can cancel the contract and have your money refunded.

So, try an annuity and “return it” if you don’t like it.

All in all, annuities are just another tool to add to your financial planning toolbox. Hopefully, we’ve given you enough information about annuities to pique your interest in how they may help you and your loved ones.

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