Have you heard about annuities, but you have no idea how they can benefit you? If you told a financial advisor that you were looking for a way to have reliable income when you age, they most likely have tried to sell you an annuity. But do you know the Pros and Cons of Annuities for a Reliable Income?
These complex financial products can provide you with a steady income stream for your retirement needs, but are they suitable for you and your financial situation?
If someone has tried to sell you an annuity, but you aren’t sure if it is worth it, you’re going to want to continue reading on below. In this annuity guide, we will cover all you need to know about annuities so you can make the right decision for yourself and your family.
- 1 How Do Annuities Work? Pros and Cons of Annuities for a Reliable Income
- 2 Benefits of Annuities
- 3 Disadvantages of Annuities
- 4 Who Should Not Buy an Annuity?
- 5 Alternatives to Annuities (Pros and Cons of Annuities for a Reliable Income)
- 6 Alternatives to Indexed or Variable Annuities
- 7 Learn More
How Do Annuities Work? Pros and Cons of Annuities for a Reliable Income
An annuity is a contract between an insurance company and a person. The investor agrees to contribute a sum of money either through scheduled payments or up-front. The insurer promises to pay them a stream of reliable income in exchange.
With an immediate annuity, you can receive that income almost right away. With deferred annuities, the income starts at a later designated time, usually around retirement. Your income payment amount is determined by the available balance in the account and your age.
You can have your annuities structured to pay income for a specific number of years. This can be ten years, 20 years, or for the owner’s life.
Any remaining money will go to the insurance company when the annuity owner dies. However, if they lived for many years, the insurance company will need to continue making their payments.
Annuities can also be variable or fixed. The insurance company pays a specific rate of return with fixed annuities, whereas, with variable annuities, the insurer invests that money in a portfolio of mutual funds. The investor has the opportunity to choose these “subaccounts,” and the rate of return will fluctuate based on the performance of those accounts.
Benefits of Annuities
Although you may have heard otherwise, some benefits come with annuities, such as guaranteed income. The insurance company must pay you a reliable income as promised, regardless of how long you live.
That promise is only as good as the insurance company backing the promise. If you plan on working with an insurance company, make sure that you only partner with insurers with high ratings and strong financials.
Variable annuities can offer you a number of professional money-management features, such as periodic portfolio rebalancing. Periodic portfolio rebalancing works best for investors who prefer to leave the work to someone else.
You have the opportunity to alter or customize the features of your annuity to meet your needs best. For example, if you add on a death benefit, you can ensure that your beneficiaries will receive financial compensation when you pass away.
A guaranteed minimum income benefit rider will pay a certain payout regardless of how well your mutual funds performed with your variable annuity. Another way to customize your annuity is to add a joint and survivor annuity.
The joint and survivor annuity will provide continued income for your surviving spouse. Keep in mind that adding on these riders will increase your insurance premium.
Disadvantages of Annuities
Although annuities come with considerable benefits, there are a few disadvantages you should keep in mind. For example, annuities come with tax penalties. If you are under the age of 59 and a half, you will have to pay a 10% early withdrawal penalty on any money you take out.
If you need to get money out of your annuity before a certain period of time has passed, you may have to pay surrender fees. These fees are usually pretty high, and it is up to the insurer’s discretion to set that fee rate.
Commissions for selling annuities are much higher than commissions from selling a mutual fund. Let’s say you roll $500,000 from a 401(k) into an IRA. If you invest the money in mutual funds, your financial advisor may take a 2% commission for their services.
Your financial advisor can take a higher commission if the money is invested into an annuity that holds similar mutual funds. On average, most advisors take about 6% to 8% or more as a fee.
Many annuities come with high expenses, and sometimes contracts are hard to understand or ascertain. The high expenses on these contracts serve to erode returns, especially with variable annuities where the value depends on the investment returns on your sub-accounts.
Once you reach the annuitization, also known as the payout phase, of your contract, you surrender the principal you deposited. This causes you to lose ownership of the money.
When you surrender the principal, it transfers to your insurance company in exchange for regular income payments. This could create a complex scenario if you intended to leave a legacy or desired flexibility in responding to the market.
Who Should Not Buy an Annuity?
An annuity has the potential to strengthen your retirement plan, but there are certain cases where it may not be a good idea. For example, if you are in poor health, you may not want to get an annuity.
Annuities have ways to guarantee that you will receive income for a certain amount if you die too soon. However, if you are already in poor health, better options may be available for you than an income annuity.
Adequate Guaranteed Income Sources
If you have Social Security income in addition to a pension that can outlive you, you may not need an annuity. You may be better served to put your financial resources somewhere else.
You Don’t Have Adequate Liquid Savings
Annuities work best when you use some of your savings to purchase the guaranteed income annuity. However, if buying an annuity leaves you without enough savings to cover unexpected needs, an income annuity may not suit you and your financial situation.
Alternatives to Annuities (Pros and Cons of Annuities for a Reliable Income)
If you find that annuities do not serve you and your financial needs, you can opt for a bond or a certificate of deposit. There are other options, such as dividend-paying stocks and retirement income funds as well.
A bond is essentially a loan that you make to a corporation in return for a specific interest rate and a guarantee that you will receive the principal back after a set amount of time. Bonds are usually the safest and the most liquid investments.
There are different types of bonds, including corporate and municipal bonds and U.S. Treasuries bonds. Each of these bonds comes with its own yields and interest rates, and they mainly depend on the lender.
Certificates of Deposit
Certificates of deposit, also known as CDs, are a special type of savings account that credit unions and banks offer. CDs typically have higher interest rates than most traditional savings accounts, but there is a slight catch.
Because you receive a higher rate of return, you have to agree to not having access to the account until a predetermined time. CDs are very safe because they are backed by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. Just like fixed annuities, certificates of deposits have a guaranteed rate of return and a guarantee on the principal.
Retirement Income Funds
A retirement income fund, also known as RIF, is a mutual fund that uses a more conservative approach to investing. These funds usually have a mix of fixed-income equities and securities.
The goal with retirement income funds is to have consistency, not maximum gains. Retirement income funds are also known as managed payout funds.
RIFs are designed to produce steady returns with regularly scheduled payments. They also have higher yields than bonds or CDs.
Unfortunately, because retirement income funds are exposed to market risk, they do not guarantee returns. Some fund managers may need to access your account to meet your payout schedule.
Alternatives to Indexed or Variable Annuities
Indexed or variable annuities carry a higher risk than fixed annuities because a portion of your income is tied to the performance of the market. The most popular alternative to variable annuities are variable life insurance policies.
Variable Life Insurance
Variable life insurance policies are contracts with insurance companies that grow tax-deferred. The point of variable life insurance is to provide income to your family members or other beneficiaries upon your death.
These policies also have cash values attached that vary based on the policy’s expenses and fees, how your money performs in your investment accounts and the premiums you pay. You may also be able to put a portion of your premium payments into a fixed account that also provides you with a guaranteed minimum.
Protect Your Legacy
Now that you learned more about Pros and Cons of Annuities for a Reliable Income, Lets learn how to protect your Legacy.
Annuities come in several different varieties and can provide you with reliable income if that is what you are looking for. Some people may not benefit from annuities, especially if you are someone receiving social security benefits and a well-established pension.
If you aren’t lucky enough to have a pension, you may want to look into getting an annuity. Because annuities are complex and can be problematic, especially with their high expense contracts, you may want to reach out to your financial advisor for more guidance. If you found this article helpful and want to learn more about other tax-saving benefits, check out our blog!