Retirement Security: Is A Retirement Annuity A Smart Investment?

Investing in a retirement annuity is a complex decision that depends on your personal financial goals, risk tolerance, and retirement plans. Annuities are insurance products that provide a guaranteed income stream during retirement, often for life. They are ideal for those seeking a stable income and wishing to avoid the risk of outliving their savings. However, annuities come with high fees and complexities that potential investors should be aware of.

Annuities can provide income for life

Annuities can be immediate, where income begins almost right away, or deferred, where income starts at a future point, usually during retirement. They can also be fixed or variable. In a fixed annuity, the insurance company pays a specified rate of return on the investor's money. In a variable annuity, the insurer invests the money in a portfolio of mutual funds chosen by the investor, and the return fluctuates based on performance.

Annuities can be customised to fit an individual's needs, but this may come at an additional cost or a lower monthly income. They can be structured to pay income for a set number of years or for the life of the annuity owner. If the owner dies, any remaining money in the account typically goes to the insurance company. However, if the owner lives to a very old age, the insurance company must continue to make payments.

Annuities can provide a reliable income stream in retirement, protecting against the risk of outliving one's savings. They offer tax benefits, as payments are not taxed until the money is withdrawn. Some annuities also offer survivor benefits, allowing survivors to continue receiving payments after the annuitant's death.

However, it is important to consider the drawbacks of annuities. They often have high fees and commissions, and it can be difficult and costly to exit an annuity contract early. There is also a possibility of the insurer defaulting on payments. Additionally, annuities can be complex, and it may be difficult for individuals to understand all the fine print and risks involved.

Annuities can be customised to fit your needs

Annuities are highly customizable and can be adapted to match the buyer's needs. For example, a death benefit provision can ensure that the annuity owner's heirs will receive at least something when the owner dies. A guaranteed minimum income benefit rider promises a certain payout regardless of how well the mutual funds in a variable annuity perform. A joint and survivor annuity can provide continued income for a surviving spouse.

Annuities can also be immediate or deferred. Immediate annuities are often purchased by people of any age who have received a large lump sum of money and who prefer to exchange it for future cash flows. Deferred annuities are structured to grow on a tax-deferred basis and provide annuitants with guaranteed income that begins on a date they specify.

Annuities can also be fixed, variable, or indexed. Fixed annuities provide a guaranteed minimum rate of interest and fixed periodic payments to the annuitant. Variable annuities allow the owner to receive larger future payments if the annuity fund does well and smaller payments if its investments perform poorly. Indexed annuities are fixed annuities that provide a return that's based on the performance of an equity index, such as the S&P 500 index.

While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to them, usually for an extra cost. This allows them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value.

Other riders may be purchased to add a death benefit to the agreement or to accelerate payouts if the annuity holder is diagnosed with a terminal illness. The cost of living rider is another common rider that will adjust the annual base cash flows for inflation based on changes in the consumer price index (CPI).

Annuities offer tax benefits

The tax treatment of an annuity depends on whether it is a qualified or non-qualified annuity. A qualified annuity is generally funded with pre-tax dollars through an employer-sponsored retirement plan, and the entire amount of withdrawals or payments is taxable as income. On the other hand, a non-qualified annuity is funded with after-tax dollars, and only the earnings portion of withdrawals is taxed as ordinary income. The premium or principal amount is not taxed.

It is important to note that annuities may also come with high fees and surrender charges, and the complexity of annuity contracts can make it difficult to understand the full extent of internal expenses. As such, it is recommended to consult a financial advisor or tax professional before investing in an annuity.

Annuities are flexible

Secondly, annuities can be held within a retirement plan, such as a 401(k) or IRA, or outside of a retirement plan. This gives you the flexibility to choose the option that best suits your financial goals and needs.

Additionally, annuities can be customised to match the buyer's needs. For example, you can add a death benefit provision to ensure your heirs receive something when you die, or a guaranteed minimum income benefit rider to promise a certain payout, regardless of the performance of the mutual funds. However, these customisation options often come at an additional cost.

Finally, annuities can be transferred from one company to another through a 1035 exchange, allowing you to move your money without incurring tax penalties. This flexibility can be useful if you want to switch annuity providers or change the terms of your annuity.

Annuities can be complicated

The contractual language in an annuity is complex, and it can be difficult for the average person to understand what their rights and responsibilities are, and what they're getting for their money. Annuities can differ markedly from one another, making it difficult to compare them. The variety of riders available, each offering different features, can also drive up the overall cost and complexity of an annuity contract.

Because of this complexity, many employers don't offer annuities as part of an employee's retirement portfolio. However, the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019 loosened the rules on how employers can select annuity providers, and includes annuity options within 401(k) or 403(b) investment plans. This may result in more investments by qualified employees in annuities.

Annuities are also subject to complicated tax considerations. For example, in the US, if you withdraw money from an annuity before the age of 59 and a half, you'll typically pay a 10% tax penalty on either the entire amount or just the earnings and interest.

Frequently asked questions