Before we get into the pros and cons of annuities, we want to emphasize something upfront. It’s important to remember financial vehicles are situationally dependent. Therefore, whether or not a tool is good or bad has to do with your personal financial situation and goals. Thus, it’s difficult to make a generalization that annuities are good or bad. Rather, it’s more important to focus on the financial vehicle’s user i.e., their background, needs, and goals.
What is an annuity?
An annuity is a contract between you and an insurance company. You pay for the annuity through a lump sum or multiple payments. If you use an annuity as a retirement vehicle, they can provide income during retirement.
There are two general types of annuities: immediate annuities and deferred annuities. Immediate annuities pay you for a specified time frame after you have irrevocably given the insurance company a lump sum of money. A deferred annuity is one in which you invest a lump sum or invest periodically and maintain control over the lump sum.
You can invest in numerous types of deferred annuities such as:
- A variable annuity gives you the opportunity to invest your money in certain types of mutual fund-like investments.
- A fixed annuity grows via a set interest rate, similar to a CD.
- An indexed annuity earns returns based on the performance of an associated index
But like all financial products, there can be some downsides. It is essential to understand both the pros and cons of annuities before you decide whether or not an annuity is right for you.
Benefits of annuities
Annuities are the only financial product that can provide guaranteed income for a set period of time. However, every annuity contract is unique. And the benefits you get from an annuity will depend on which insurance company you buy it from.
Some benefits that annuities may provide:
- A guaranteed stream of income for life, which is good for those who want a stable source of income during your lifetime.
- Tax-deferred growth of otherwise taxable investments, which offers investors a method to defer paying taxes on their investment earnings.
- Higher, more stable returns than traditional fixed-income investment.
- Ability to add various types of “riders” such as a long-term care rider for an additional cost.
- Death benefits to beneficiaries for an additional cost
Downside to Annuities
This all sounds well and good, but what’s the downside? Let’s take an example and say you’re using the annuity like a CD. When you have a five-year CD and need to take money out after just one year, you’ll have to pay an interest charge. With annuities, it’s called a surrender penalty. This charge can be a significant amount (e.g., 10 percent of the principal) and can last a long time.
As you can see, annuities can work well when your money grows tax deferred. But they can be problematic if you have to deal with surrender charges. One of the big issues with annuities is that commission-based sales people have traditionally sold them. Therefore, there are times when people buy annuities when it’s not appropriate for them.
For example, if there’s a good chance you are going to need money to pay for a near term expense, an annuity probably isn’t the best investment tool for you. Most people rely on experts to identify issues when signing off on all of the legalese involved with a financial tool. Unfortunately, commission-based sales people may not bring surrender penalties or other nuances involved with annuities to your attention. Why? They’re motivated to make a sale rather than considering your best interest.
Other cons of annuities include:
- Contracts are complex
- Fees and commissions can dilute your investment
- You have limited access to your money
- Payments do not keep pace with inflation
Summary
Annuities can serve an important role within a portfolio. You just need to be careful how you’re using them. Therefore, if you’re going to use annuities as a financial tool, consider using them through a financial planner who is a registered investment advisor and has access to other investments. The expert will be able to compare and contrast annuities versus other financial tools available to you. The investment advisor can advise you where (if at all) the annuities will add value to your portfolio. As we stated previously, there are many different types of annuities so it’s critical you have someone with expertise to help you make these types of financial decisions.
Listen to more about annuities in our Financial Fridays Podcast.
