Insurance agents and financial advisors have been investing their clients’ retirement money in annuities for decades. This practice has its detractors, with critics generally focusing on the high commissions paid to annuity sellers and the high fees charged to annuity holders year after year. Here’s an overview of the pros and cons of annuities, compared to other ways to invest for retirement.
Key points to remember
- Annuities can provide a reliable stream of income in retirement, but if you die too soon, you may not get your money’s worth.
- Annuities often have high fees compared to mutual funds and other investments.
- You can customize an annuity to suit your needs, but you’ll usually have to pay more or accept a lower monthly income.
How Annuities Work
An annuity is a contract between an individual and an insurance company. The investor pays a sum of money, either fully upfront or in installments, and the insurer agrees to pay them a steady stream of income in return.
With a immediate annuity, this income starts almost immediately. With a deferred annuity, it begins at some point in the future, usually during retirement. The dollar amount of income payments is determined by factors such as account balance and age of the investor.
Annuities can be structured to pay income for a set number of years, such as 10 or 20, or for the life of the annuity owner. When the owner dies, any money left in the account usually belongs to the insurance company. However, if they live happily to, say, 135, the insurance company still has to maintain those regular payments.
Annuities can also be fixed or variables. In a fixed annuity, the insurance company pays a specified rate of return on the investor’s money. In a variable annuitythe insurer invests the money in a portfolio of mutual funds, or “sub-accounts”, chosen by the investor, and the return will fluctuate according to their performance.
The benefits of annuities
Despite the criticisms, annuities offer certain advantages to investors contemplating retirement.
The insurance company is responsible for paying the income it has promised, regardless of the lifetime of the annuity holder. However, this promise is only as good as the insurance company that backs it. This is one of the reasons why investors should only do business with insurers whose financial strength is well rated by large companies. independent rating agencies.
Annuity contracts can often be tailored to suit the buyer’s needs. For example, a death benefit This provision can ensure that the annuity holder’s heirs will receive at least something upon the holder’s death.
A guaranteed minimum income benefit endorsement promises a certain payout regardless of mutual fund performance in a variable annuity. A joint and survivor annuity can provide ongoing income to a surviving spouse. All of these features come at an additional price though.
Assistance with financial management
Variable annuities can offer a number of professional money management features, such as periodic portfolio rebalancingfor investors who prefer to leave that job to someone else.
The disadvantages of annuities
When it comes to commissions paid for selling annuities versus mutual funds, the former is almost always higher than the latter. Suppose an investor deposits a balance of $500,000 in a 401(k) into an Individual Retirement Account (IRA). If the money is invested in mutual funds, the financial adviser could receive a commission of around 2%. If invested in an annuity that holds the same or similar mutual funds, the advisor could make a commission of 6% to 8% or even more.Therefore, a $500,000 rollover in mutual funds would earn the advisor a commission of at most $10,000, while the same rollover in an annuity could easily pay the advisor $25,000 to $35,000 in commission. Unsurprisingly, many advisors will refer their clients to the annuity.
Most annuities do not estimate sales charges in advance. It can make them look like empty investments, but that doesn’t mean they don’t have a lot of fees and expenses.
Annuity contracts impose annual maintenance and operating fees that often cost significantly more than the expenses of comparable mutual funds. This has changed somewhat in recent years, and some insurers now offer annuities with relatively low annual rates. expense ratios. Still, as always, investors should carefully review the fine print before signing.
If an annuitant needs to withdraw money from the annuity before a certain period of time has elapsed (usually six to eight years, but sometimes longer), they may be subject to severe redemption fee billed by the insurer.
If the annuitant is under age 59.5, they may also have to pay a 10% early withdrawal penalty on any amount they withdraw.
No additional tax benefits in IRAs
Annuities are already tax sheltered. Investment income grows tax-free until the owner begins to receive income. If the annuity is a qualified annuitythe owner is also entitled to a tax deduction for the sums he pays into it each year.
A traditional IRA or 401(k) has the same tax advantages, however, and generally at a much lower cost if invested in conventional mutual funds. So putting an annuity in an IRA, as investors may be urged to do by some eager salespeople, is redundant and unnecessarily costly.
If you’re considering buying an annuity, make sure you’re dealing with a financially sound insurance company that will likely be there and able to deliver on its promises when you start earning income.
A compromise solution
A practical option for investors is to stick with mutual funds until retirement, then roll some of their money into an annuity, especially one with a downside protection rider. This keeps costs to a minimum during the investor’s working years, but guarantees a stable income in retirement.