Know the Pros and Cons

What Is a Retirement Annuity?

A retirement annuity is a financial product that provides an income in retirement. It is similar to insurance (some annuities are regulated as insurance products) in that you make regular payments to the annuity company. In return, the annuity company will pay you a set amount of money periodically, with the timeline specified in your annuity contract.

In some cases, an annuity payment can continue after a retiree’s death and be paid to a spouse.

These products are designed to provide a reliable income during retirement that will last as long as you live. While this is appealing to many workers who are concerned about their ability to save enough for retirement, annuities often have drawbacks, particularly their costs and fees, compared with other retirement investment accounts.

Before purchasing a retirement annuity, it is important to understand the advantages and disadvantages.

Advantages of Retirement Annuities

Retirement annuities have several benefits, such as…

• Lifelong income
• Deferred taxes
• Guaranteed rates of return
• The possibility of growth

Lifelong Income

The main appeal of a retirement annuity is the guaranteed income that can last for the remainder of your life. “For people who are more cautious and want less risk, annuities can offer some peace of mind with a predictable stream of income,” says Melissa Joy, CFP, CDFA, founder of Pearl Planning. With an annuity, you don’t have to worry about outliving your retirement savings, no matter how old you live.

Deferred Taxes

With some investments, such as certificates of deposit (CDs), you may owe taxes when they reach maturity. However, you won’t owe taxes on an annuity until you withdraw funds. This can help you manage your tax burden strategically throughout retirement.

Guaranteed Rate of Return

Fixed annuities have guaranteed rates of return. You know exactly how much you’ll receive monthly once you start claiming your annuity payments. This guaranteed income can provide peace of mind, in addition to making retirement planning easier by allowing you to plan which sources of income you will tap into at different stages of retirement.

Possible Market Growth

Variable or indexed annuities trade predictability for the possibility of growth. These annuities allow you to benefit from a strong market and receive a higher income than you might otherwise expect.

Disadvantages of Retirement Annuities

While retirement annuities have many advantages, they must also be carefully considered for their disadvantages, which include…

• Complex contracts
• High fees
• How they are taxed
• Illiquidity
• Inflation risks

Complex Contracts

Annuity contracts can contain many riders and extra provisions, which can quickly become complicated. “Each product has its own set of rules and features, and that leads to a lot of confusion,” says Joy. “If you’re going to pay for those fancy features, make sure you have a plan to actually use them.”

High Fees

Annuities often have many fees and penalties baked into them. “The costs can be steep,” Joy warns. “There are fees and penalties. There might be surrender charges or ongoing expenses. A lot of times annuities get sold with riders which enhance the guarantees you get but come with more costs.”

Even without additional penalties or riders, the basic costs of annuities can be up to 3% per year. “If there’s not a clear conversation on costs with the person selling you the annuity, that’s a red flag,” says Joy.

Taxed As Ordinary Income

Taxes on annuities can be complex. While taxes on the interest and investment gains are deferred, once you take withdrawals, the net returns are taxed as ordinary income. In most tax brackets, this is much higher than the rate you would pay on investments that qualify for the capital gains tax rate.

Lack of Liquidity

Many annuities have a surrender fee, meaning you’ll pay a substantial penalty if you try to take an early withdrawal. The surrender period will depend on the type of contract you sign, but six to eight years is typical.

“Annuities are not a good fit for people who want a lower-cost portfolio or people who want more control over when they can access their funds,” Joy advises. “You need to know what you’re getting into.”

No Inflation Adjustment

The guaranteed income of an annuity can be comforting if you’re worried about running out of money in retirement. But unlike the Social Security system, annuities don’t have a cost of living adjustment built in.

“They aren’t necessarily structured to take inflation into account,” explains Joy. “So what you’re agreeing to today might not be worth as much in future dollars.”

Types of Annuities

It’s important to understand the different types of retirement annuities available to fully understand their benefits and drawbacks. While the specific structure of an annuity will depend on the company offering it and the terms of its contract, most consumers will be able to choose between a few common options.

Fixed vs. Indexed vs. Variable Annuities

A retirement annuity is typically funded with either a lump-sum payment or a regular series of payments, similar to an insurance premium. However, the income you receive from it once annuitization begins will depend on whether you select a fixed, indexed, or variable annuity.

A fixed product provides a set payment that remains consistent over the life of the annuity. With a fixed annuity, you know exactly how large your payments will be and for how long you will receive them.

An indexed annuity is an insurance contract with a rate of return pegged to a stock market index such as the S&P 500. This allows you to receive higher payments when the stock market is doing well but, because it follows a broad index, has less risk associated with it than a variable annuity.

A variable annuity is the riskiest type of annuity, though it also has the greatest possibility for growth. The rate of return for these annuities is based on the performance of investment options that you choose when you purchase your annuity.

For all these types of annuities, you also select the length of the annuity, which can be:

• A set number of years
• Your lifetime
• Your lifetime plus your spouse’s lifetime

Immediate vs. Deferred Retirement Annuities

An immediate annuity is funded by a lump sum payment and begins paying you an income right away. This type of product is also known as an immediate payment annuity or an income annuity. It’s usually appropriate for those who are already retired or just entering retirement and choose to put their retirement nest egg into an annuity to create an immediate and dependable income stream.

A deferred annuity, or deferred payment annuity, is generally part of a long-term retirement plan. It can be funded by either a lump sum or regular payments, but it doesn’t begin paying you an income until the date specified in your contract. If it is a fixed annuity, your money will accrue interest during that time. If it is an indexed or variable annuity, your money will grow if market conditions allow. However, there is the risk of loss if the market declines and doesn’t recover by the time you need to begin making withdrawals.

The Bottom Line

Annuities can be a helpful part of retirement planning for many people, but they aren’t a one-size-fits-all solution. Though they provide a reliable and predictable income that can last the rest of your lifetime, they also come with substantial costs. They can make it difficult to access more money in an emergency.

“Just like you should have a well-balanced portfolio, having well-balanced sources of income in retirement is so important,” says Joy. If you are trying to decide whether annuities should be part of your retirement income, a financial planner can help you create a retirement portfolio that fits your needs and lifestyle.