The promise of annuities for retirement planning almost sounds like a retirement dream come true. A guaranteed source of income you cannot outlive? What could be better? While annuities can make sense for a small portion of your portfolio in very specific situations, it is important to educate yourself and carefully weigh the pros and cons before making a purchase.
Here, we offer an overview of annuities and important considerations to keep in mind before you commit.
What is an annuity?
An annuity is a contract offered by an insurance company that guarantees a set of regular payments in exchange for a premium payment or series of payments. Annuities are commonly used by retirees to provide a regular income stream. There are three main types of annuities:
- Fixed annuity – A fixed annuity guarantees a minimum rate of return that can increase annually or be reset periodically.
- Variable annuity – A variable annuity invests your premium payments with a goal of generating investment returns. The performance of the investments determines your earning potential.
- Indexed annuity – An indexed annuity mirrors the performance of a specific index, such as the S&P 500, offering a maximum return based on the total return of the index. Some indexed annuities also offer a minimum return level.
Benefits of annuities
Annuities offer several benefits that can make them seem like an attractive source of retirement income, such as:
- Regular payments –Annuities typically provide monthly payments to support your income in retirement.
- Guaranteed lifetime income –Annuities can be structured to provide guaranteed income that lasts the rest of your life. Having a source of income you cannot outlive can be an attractive benefit for many retirees who worry about running out of assets partway through retirement.
- Guaranteed investment returns –Fixed annuities offer a guaranteed rate of return, which helps calm the fears of retirees who worry about market volatility.
- Tax-deferred growth –Your premium payment is able to grow tax-deferred within the annuity, and you do not pay taxes on the assets until you withdraw them in retirement.
- Survivor benefits –Some annuities offer an option to designate beneficiaries who can continue receiving payments after your death.
Disadvantages of annuities
While annuities may sound like a retirement income dream come true, the disadvantages sometimes outweigh the benefits — especially if you overcommit your capital. Before purchasing an annuity, carefully consider the following drawbacks:
- Fees –Annuities can be incredibly expensive. When you purchase an annuity, you generally pay fees to the insurance company that holds the policy, the broker who sold you the annuity and the investment manager responsible for investing the underlying funds.
- Illiquidity –It can be difficult to exit an annuity once you have paid the premium. Some insurance companies impose high surrender fees that can add up to more than 10% of the contract’s value. And, because annuities typically have a limited surrender period, you may not be able to exit or access the funds when you want without penalty.
- Complexity –Annuity contracts can be incredibly complex. Insurance brokers often target individuals who are afraid of outliving their assets and swayed by the promise of receiving a guaranteed source of income throughout retirement. These individuals may let their fear cloud their judgement, entering into a complex contract without truly understanding the product and its risks.
- Loss of control –Once you surrender your premium to an insurance company, you may lose control over how your assets are invested or have very limited options for investing.
- Credit risk –The promise of an annuity is only as strong as the insurance company that backs it. If the insurance company faces financial challenges or goes out of business, your retirement income could be at risk.
- Inflation risk –Fixed annuities, in particular, may struggle to keep up with inflation, potentially leading to a decrease in your long-term purchasing power.
At United Capital Financial Advisors, we believe in thoroughly weighing the risks and the benefits of incorporating annuities as part of a retirement plan. There are generally more effective and flexible ways to generate income in retirement than through an annuity. Our approach to retirement income involves establishing a custom financial plan, implementing and maintaining a diversified investment portfolio, and following a disciplined, tax-efficient withdrawal strategy. This approach can help you establish a reliable stream of retirement income.
If you could use some help establishing a reliable stream of retirement income, we would love to have a conversation. To learn more, please contact us.
