Many people approaching retirement automatically ask, “What are the top retirement annuities?” or “What are the best annuities for retirement income?” But before even looking at retirement annuity rates or checking an annuity rates calculator, there is a prior question. Should we even use annuities in retirement planning? Depending on who you talk to, the concept of using annuities to fund retirement is either the best thing since sliced bread, or something to entirely avoid. So, let’s consider the pros and cons of annuities for retirement.
An annuity is a lump sum of cash we invest at some point in our lives to produce a monthly stream of income for a fixed period, or for life. This stream of income can start when invested, or shortly thereafter (30 days or so), with an “immediate annuity,” or in the future with a “deferred annuity.” Any of the funds you invest in an annuity are not protected or insured by the issuers.
Annuities come in several different types. The size of your future monthly income stream is also not always predictable, it will depend on whether or not your annuity is “fixed” or “variable.” To give you a bit of a working knowledge, let’s consider some definitions.
- A variable annuityis a tax-deferred retirement vehicle that allows you to choose from a selection of investments, and then pays you a level of income in retirement that is determined by the performance of the investments you choose. A fixed annuity provides a guaranteed payout – a better option when interest rates are higher.
- An indexed annuity is tied to an index, like the S&P 500, and as such offers protection since it guarantees a minimum return. You’ll want to consider the interest rate environment affecting this type of annuity.
- A longevity annuity may be wise if you’re concerned about outliving your assets and you have the means to lock up some of your assets in an annuity.
For example, Mary is 73, in good health, and has longevity in her family. She puts no more than 15% of her investments into a deferred fixed annuity. Alice will begin to receive monthly income from the $150,000 investment when she turns 80; these payments will continue until she passes away. If she dies before receiving any payments, the principal may be returned to her without interest, but she may forfeit the entire annuity if she passes away after she begins to receive her stream of income.
- Charitable annuities can be a wonderful way to make a tax-deductible donation to a charity and to receive a portion of the donation as a stream of income for life.
Pros & Cons of Annuities for Retirement
- Guaranteed Income. Are you retired already or close to it and want a guaranteed income stream to add to your portfolio? Well, maybe you should consider an annuity.
- Interest Rates. If you’ve chosen a fixed annuity and interest rates fall, you’ve essentially locked in the higher rate.
- Investment Performance. If you’ve chosen a variable annuity and your investments perform well, you benefit from that and your income increases.
Remember the downsides of annuities, too.
- Liquidity. The cash you put into an annuity is tied up, so you’ll want to make sure your portfolio is ready for this.
- Interest Rates. If you’ve chosen a fixed annuity and interest rates go up, you’ve essentially locked in the lower rate.
- Investment Performance. If you’ve chosen a variable annuity and your investments decline in value, so does your income. To protect yourself, ask about a living benefit income rider that will guarantee a certain level of income.
- Fees. There are big fees to consider, so be sure you understand the expenses, management fees and surrender charges you’ll encounter if you try to get out of the contract. There also may be fees for additional features like a living benefit income rider (mentioned above).
- Tax Consequences. You can also think of your annuity as a mutual funds run through an insurance company in order to get a tax deferral. Ask yourself, have I maxed out my savings contributions in other tax-advantaged plans (i.e. 401(k)s and IRAs). If not, an annuity might not be the best choice. The tax deferral means you pay no taxes on the income and investment gains until you withdraw the money. This opens up another can of worms – tax consequences.
- If you are in a low tax bracket now, prior to retirement, and then buy an annuity with after-tax dollars (to defer investment income) you may be disappointed if your income tax bracket ends up as high or higher in retirement due to (a) significant RMD distributions from an IRA or 401(k) and (b) the fact that tax rates overall likely will rise further in the future.
- Or, when purchasing with after-tax dollars, you’ll be swapping lower capital gains tax rates on taxable income to higher ordinary income tax rates on all annuity gains.
You can counsel with your tax preparer for more information on the potential tax liability issues.
- Commissions. A word of warning here, too, is that annuities are commissionable, and depending on your salesperson, they may or may not have your best interest at heart if they see dollar signs in their own eyes from the commission they will earn based on your decision. Choose your expert wisely. You will want to look for someone who is taking your whole financial picture into account, not just the sale of one piece. An annuity should be a compliment to other investment vehicles you may already have in place.
Just as each of us are different from a physical standpoint, our financial health can also set us apart and what may be perfect for your neighbor may not be the proper fit for you and your retirement financial picture. Before making any investment decision, consider the investment objectives, risks, charges, and expenses of your investment options. In addition, we are not tax advisors, estate planners, or investment experts. So, please take this information to your own planner to begin the discussion of what is right for you and your situation.
Annuities are popular. They can be a very effective add-on to an already strong retirement portfolio. Be sure you are informed on what is the best for you. Don’t just purchase an annuity because your friends are.
Do your homework, listen to a trusted investment expert. Consider carefully the pros and cons of annuities for retirement. The goal is to enjoy your retirement without worrying that you will outlive your assets.