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Are You Considering Investing in an Annuity? Our Top 10 Pros and Cons to Buying An Annuity

annuity pros and cons

There’s no “right” way to invest or save for retirement.  Like so many things in life, the best approach for one person might not work for another.

Annuities fit perfectly into this pattern.  A blanket conclusion that annuities are or are not a good investment ignores the fact that every investor is different.

And so, in evaluating annuities, you need to consider the pros and cons relative to the needs and preferences of a given investor.

You see,

…annuities have a lot of advantages.  They’re reliable, virtually risk-free, versatile, and come with some attractive tax benefits.

On the other hand,

…annuities also have some drawbacks.  They are a low-liquidity investment that requires a substantial time commitment.  They are sometimes complicated.  And they do not have the upside potential of more high-risk investments.

So, whether an annuity is a good fit for you depends on

your individual circumstances, your goals, your needs, your preferred risk profile, and even your personality.

But, before you can decide whether an annuity might be appropriate in your situation, you need to know a little something about how they work, what they can do, and their limitations.

What are Annuities?

An annuity is, at its core, a contract between a life insurance company and an individual (the “annuitant”) under which—in exchange for one or more premium payments up-front—the insurance company promises to make regular, guaranteed payments over a period of time.

And once the insurer receives the premium, the annuity earns interest, which can be fixed or variable.

Payments sometimes start immediately and are sometimes deferred. They can continue for the rest of the annuitant’s life (a “lifetime” or “life income” annuity) or for a defined term, usually a period of years.

SPIA

What you might consider the classic annuity is known as a SPIA – single premium income annuity.

With a SPIA, you make one large, lump-sum premium payment, and the insurance company guarantees that it will make regular annuity payments to you for the rest of your life, regardless of how long that ends up being.

The payment amounts are based, in part, on your life expectancy.

So, if you live significantly longer, you end up receiving a lot more out of the annuity than you put into it.

But the opposite is true, too.  SPIAs provide a good benchmark to compare the many other annuity variations that are available today.

Types of Annuities

For the most part, every annuity will be either single or flexible premium; either immediate or deferred; either fixed or variable; and either life or term.

How a specific annuity fits into each of these categories makes a big difference in deciding whether it is a good fit for an individual investment or retirement plan.

Single vs. Flexible Premium:

A single premium annuity requires only one large premium payment, due when the annuity contract is executed.  This allows for a great deal of predictability and can be useful in converting a large legal settlement, inheritance, or other lump sum into an extended income source, potentially resulting in significant tax savings.

Flexible-premium annuities allow you to pay premiums over an extended period, gradually building up the annuity’s value for future use.  They can be a good option for someone nearing retirement age who wants to build up a nest egg via a low-risk investment.

Immediate vs. Deferred:

Immediate annuities start paying out right away.  You purchase the annuity and, within the next month or so, you’re already receiving payments back.  Immediate payments can be useful for recent retirees who want to convert some of their savings into a consistent income stream.

Deferred annuities don’t begin paying out until a future date, allowing for larger eventual payments because the insurance company has more time to invest the premium before paying out. A tax-qualified deferred annuity can be a great way to reduce current taxes as you approach retirement age.

Life vs. Term:

Lifetime payments are what traditionally defined an annuity.  A life income annuity basically works like a private pension or Social Security payment, providing a hedge against “longevity risk,” the risk of outliving retirement savings.

A term annuity defines in advance how long payments will continue, which allows heirs to receive continued payments if the annuitant dies before the end of the term.

Riders are also available for lifetime annuities that provide for a refund of any unpaid premium if the annuitant dies before the annuity has paid out at least as much as the premiums paid in.

Similarly, “life with period certain” annuities pay out for life but are also guaranteed to continue paying for at least a defined number of years.

Fixed vs. Variable:

A fixed annuity grows at a steady, preset rate of interest, regardless of overall market performance.  The rate is usually comparable to, or a little better than, a CD.

The growth of a variable annuity is tied to investment performance, though, in many cases, the insurance company guarantees a minimum growth rate.

“Fixed indexed” annuities are a relatively new variation in which growth is linked to an equity index (e.g., the DOW or NYSE).  The maximum rate of growth is capped, but the insurer usually also provides a no-loss or minimum growth guaranty.

Advantages of Annuities

Probably the most obvious pro of annuities is they have been designed to serve as a hedge against “longevity risk.”  By providing a guaranteed, secure source of regular income for the rest of your life, annuities mitigate the danger of lasting longer than your retirement savings.  For this reason, they are often referred to as “reverse life insurance.”

But that isn’t the only advantage annuities have.  Even if you have little risk of outliving your savings, annuities can be a valuable tool for retirement planning because they are dependable, low-risk, and come with attractive tax advantages.

Reliability:

Like clockwork, annuities provide a predictable, steady stream of income.  Most retirees need to stick to a budget, and budgeting is much easier when you know exactly how much money will be coming in and when.

An annuity payment sufficient to cover fixed expenses provides the peace of mind that comes with knowing that, regardless of what markets do, the bills will get paid.

And, when you know the money will be there from the annuity, you can afford to apply other assets toward investments with greater risk but greater potential upside.

Along the same lines, an annuity payment that covers the essentials can help you avoid cashing out other assets when markets are down.

Zero Risk:

Sometimes, just knowing that there is no risk of losing money is attractive.  Annuities have essentially no risk of loss, removing the uncertainty and volatility involved with the stock market.  So, if principal protection is a priority, an annuity may be a good option.

Most annuities grow at a rate better than a savings account or CD, with a comparable risk profile.  The rate you’ll get with a fixed annuity is lower than historic stock market returns, but the idea is that you’re trading potential upside for eliminated risk.

If you’re willing to accept a little risk, variable annuities let you enjoy higher returns in strong markets.  However, if investments perform poorly, annuity payments decrease, though even variable annuities often come with a guaranteed minimum return rate.

Fixed indexed annuities also allow for increased upside by tying growth to the performance of an equity index.  Typically, growth is subject to an earnings cap, and losses are either absorbed by the insurer or limited to a small percentage.

The reduced risk profile makes annuities a good choice for investors who need to keep risk to a minimum.

So, if you’re recently retired or plan on retiring soon—or if you’re investing money set aside for a child’s education—an annuity may be appropriate.

Or, if you are just naturally sensitive to risk and want an investment you can be certain will not lose money regardless of economic contractions, annuities are worth exploring.

Tax Deferral:

As with retirement accounts, no income tax is due for growth earned by an annuity until the growth is actually received by the annuitant.

The tax deferral allows interest to stay in the annuity and compound, leading to substantially improved long-term gains.

If an annuity is timed to pay out after retirement, the tax deferral can also translate into a markedly lower marginal tax rate when the growth is eventually received.

Certain “tax-qualified” annuities are eligible for pre-tax contributions (like an IRA) but are not subject to any annual contribution limit (unlike an IRA).

So, if you’re behind schedule for retirement savings and want to catch up, but have reached your maximum IRA contribution limit, a tax-qualified annuity can be a great investment.

Payments from tax-qualified annuities are taxable income in full when received, but the rate after retirement is usually lower than during prime working years.

Versatility:

Annuities are available with a host of riders or specialized forms that tailor an individual annuity to the annuitant’s specific needs.

“Hybrid” annuities and long-term care riders allow an annuity to help cover costs of a nursing home or other long-term care by accelerating payments if long-term care proves necessary.

In both cases, value remaining in the annuity can usually be inherited by heirs if the need for long-term care never arises.

Most insurance companies also offer riders that attach a death benefit to an annuity.

So, if life insurance premiums are too high or a permanent policy just doesn’t fit into your plan, an annuity can offer both an income stream during life and a means of providing support for loved ones or covering estate expenses after death.

There are numerous other benefits available through annuity riders that make sense in some situations but not others.  The big downside to purchasing a rider is that, along with increasing the value of the annuity, it also increases the cost.

Drawbacks of Annuities

When you purchase an annuity, you are, to a certain extent, trading liquidity and growth potential for security and stability.  Depending upon your situation, that might be a great trade, or it might not be worth it.  But if you’re thinking about buying an annuity, you need to consider the cons along with the pros.

Reduced Upside:

The biggest cons to an annuity is that you give up the chance for spectacular stock-market returns, but you also eliminate the risk of loss during a down cycle or market collapse.

And fixed indexed annuities let you participate in bull markets to a degree, but not fully.

So, if you have a high-risk threshold and don’t mind the chance of losing principal, you might not want an annuity.

On the other hand, an annuity in your portfolio can serve as a hedge that lets you roll the dice on other high-risk, high-reward investments.

It’s also worth noting that annuities are a fairly hands-off investment.  Once you execute the contract, there’s not much left to do but accept the payments when they arrive.  If you have a passion for researching stocks and funds and keeping a close eye on investment performance, an annuity won’t scratch that itch.

Low Liquidity:

Annuities usually require a long-term commitment.  Once you fund an annuity, the money is pretty well tied up.

You can access the value in an emergency, but there will likely be surrender charges during the first few years, and, if you sell an annuity to a third-party for cash, you lose money long-term.

Thus, if it’s reasonably likely that you will need to access wealth held in an annuity within the next few years—other than through the regular contractual payments—you’re probably better off with a more liquid investment or savings vehicle.

Reduced Inheritability:

Depending on the type of annuity, your heirs may not be able to inherit any of the wealth from an annuity.

Traditional life income annuities pay out for the annuitant’s life, and that’s it—heirs don’t get anything.

Annuities with a defined term, though, continue to pay out to heirs or the estate if the annuitant dies during the term.

“Life with Period Certain” annuities and principal refund riders allow for something of a compromise between the two.

The former pay for life but guaranty payments will continue for at least a defined period of years, which lets heirs receive remaining payments through the end of the period if the annuitant dies early.

Principal refund riders return any left-over premiums to a named beneficiary or to the annuitant’s estate.

Complexity:

This annuity disadvantage comes with a caveat.  Fixed, life income annuities are fairly straight-forward, but many other annuities—like variable or fixed indexed annuities—are highly complicated.

To fully understand the details of how variable annuities work requires a commitment to closely reviewing a complex contract, which some people are not eager to do.

Also, for the most part, the more moving parts an annuity has (i.e., the more complicated it is), the higher the fees will be.

The potential for improved performance and the supplemental benefits may or may not be worth the higher fees, depending on your situation and goals.

Buying an Annuity

When considering the purchase of an annuity, you will want to be well-informed about the various options that are out there, how they work, the fees involved, and how rates compare between different insurance companies.

 

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