Annuities 101

March 15, 2018

Have you ever heard a financial advisor describe the virtues of an annuity and found yourself thinking it sounds like a pretty good deal? Or maybe you are interested in an annuity because you like the idea of a guaranteed source of income when you retire? Perhaps, being the savvy investor you are, you’ve also read or heard that annuities are a rip-off and mostly benefit the agent that is selling them.

What to make of all this? As my colleague Erik outlines in this post, annuities aren’t all good or all bad. Let’s consider some common types of annuities, how they work, and the pros and cons of each. 

Immediate Income Annuity

Here’s how it works: You provide a lump sum of money to the insurance company, and in exchange, they promise to make regular payments to you right away. The amount of each payment you receive depends on your age, and the terms of the annuity (payments for your life only, your life and the life of someone else, or for a fixed period). 

Pros 

  1. Guaranteed income for the term of the annuity. 
  2. No account management or maintenance fees. 
  3. No maintenance or work once it is set up. 
  4. Reliable income which can simplify retirement planning. 
  5. You can add inflation protection to income payments (although that’s an additional cost).

Cons 

  1. Once you purchase an immediate income annuity, you lose access to your money (beyond your regular payments). The lump sum you deposited can no longer be used for emergencies (or anything else). 
  2. If you do not choose inflation protection, the purchasing power of your payment can be eroded. 
  3. If you pass away shortly after starting your payments, the remainder of the annuity goes to the insurance company unless you add a beneficiary, which requires you to purchase a death benefit and can be pricey.

Deferred Income Annuity

Here’s how it works: Like an immediate annuity, you provide funds to an insurance company in exchange for a stream of income payments. The difference is that a deferred income annuity does not require a single lump sum payment and you don’t start receiving payments until a later date. During the “accumulation phase,” when the policy is growing in value due to your payments and/or the interest rate paid by the annuity company, you can decide to make a single premium payment or a series of payments over time. Those funds then accrue interest, tax-free, until you choose to start receiving income payments. 

Pros 

  1. Interest accrues tax-deferred until funds are withdrawn. 
  2. Most deferred annuities guarantee against a loss of principal. 
  3. Guaranteed income payments for life (for you or your spouse) if you choose to annuitize. 
  4. Includes a death benefit component, so your beneficiary receives any remaining value if you pass away before the annuity ends. 

Cons 

  1. Be aware of the surrender period – a period at the beginning of the contract that prevents you from withdrawing funds without paying a surrender charge. You will also pay a penalty from the IRS if you pull funds prior to age 59 ½.
  2. Earnings are taxed as ordinary income. Principal is also taxed as ordinary income if you use pre-tax retirement money (like a traditional 401(k) or IRA). 
  3. Fees can really add up when you consider mortality and expense charges, administrative fees, charges for special features and riders, and high commissions for agents. 

Variable Annuity

Here’s how it works: Variable annuities share some common traits with fixed annuities like tax-deferred growth and various payout options. Unlike a fixed annuity, a variable annuity takes your premium money and invests it in sub-accounts that you determine based on your risk tolerance. As such, a variable annuity is a higher-risk alternative to a fixed annuity. One popular hybrid of a fixed and variable annuity is the equity indexed annuity (kudos to my colleague Cynthia for this great look at these). 

Pros 

  1. Allows you to participate in the market to maximize your return and the amount of your future income payments. 
  2. Tax-deferred growth and multiple payout options. 

Cons 

  1. You assume the investment risk – your annuity’s value is subject to loss based on sub-account performance or you may find your sub-accounts underperform if you invest too conservatively. 
  2. Limited access to money due to surrender period. 
  3. Fees, Fees, Fees! If you want to lessen the risk with a variable annuity, you can add additional riders to the contract to protect income. These can be costly, and are in addition to administrative fees, mortality expenses, and expenses associated with the investment sub-accounts you choose. Michael, a fellow planner here at Financial Finesse, covers these fees and the concern with them in this post.   

Other things to consider

  1. It’s usually a terrible idea to put all your money into an annuity. Diversify into other investments like stocks, bonds and cash to ensure you have flexibility to cover emergencies and other needs above your fixed income sources. 
  2. Make sure the insurance company is on strong financial footing. Check ratings at agencies like Moody’s, Fitch, A.M. Best and Standard and Poor’s to make sure the company you are doing business with can fulfill their promise when accepting your money. 

Tying it all together 

As you can see, annuities can be a great tool to help you increase the amount of fixed income you can bank on in retirement. This can make great sense if your other fixed income sources like Social Security and pension benefits don’t totally cover your fixed expenses.

But it is also clear that annuities, especially deferred and variable contracts, can become very expensive options to provide that income. If you are considering an annuity as part of your retirement plan, make sure you understand the benefits along with the costs and restrictions that come along with your investment.