Alternatives to Annuities

Annuities are among the safest options for long-term financial planning. They provide a reliable and steady stream of regular payments and offer an attractive choice for people looking to fund retirement, provide for loved ones or even pay for long-term care.

But, like any investment strategy, annuities carry some risk and may not be the best financial planning choice for everyone.

Fortunately, there are several sound alternatives to annuities that also generate income. These include bonds, certificates of deposit, retirement income funds, dividend-paying stocks and variable life insurance policies.

While there are many reasons to buy annuities, some consumers have common concerns about annuities’ disadvantages, including their complexity, accompanying commissions and fees and taxation rules.

Annuities provide guaranteed income for a fixed period or for life, and they usually offer high flexibility in that they offer the ability to customize benefits. The specific terms of an annuity depend on the type of annuity you purchase.

Still, an annuity might not work for you if:

Remember that annuities are insurance products.

“Like any other insurance policy that consumers own, it’s important for everyone to have enough insurance, but not too much,” Moshe A. Milevsky, a finance professor at York University and managing director of the consulting firm PiLECo, says.

If you already have many other forms of guaranteed income, like a large pension from work or ample income from Social Security, Milevsky advises that an annuity might not be needed.

Beyond annuities, there are several alternatives to consider for peace of mind and financial security. Like annuities, these alternatives come in many shapes and sizes depending on your investment goals and risk tolerance. They also come in fixed and variable options.

Many annuity alternatives still fall within the safety-first approach to retirement planning made popular by economist Zvi Bodie. This approach calls for prioritizing the funding of basic needs over discretionary spending. Because of that, Bodie and other safety-first proponents advise people to cover their essential retirement expenses with guaranteed sources of money, including lifetime annuities, Social Security, a pension, bonds and certificates of deposit.

Wade Pfau, a professor of retirement income at The American College of Financial Services, describes this approach as first building a “safe and secure income floor” for your entire retirement. Only then, he advises, should people consider more volatile assets in their retirement portfolio.

Some of the most popular alternatives to fixed annuities are bonds, certificates of deposit, retirement income funds and dividend-paying stocks. Like fixed annuities, these investments are regarded as relatively low-risk and income-oriented.

A bond is most often described as an I.O.U. Essentially, it’s a loan that you make to a borrower (usually a corporation or government) in return for a specified rate of interest and a promise that you will receive back the principal after a set time.

Bonds are generally considered to be safe and liquid investments. There are different types of bonds, including U.S. Treasuries and corporate and municipal bonds, with differing yields depending on the creditworthiness of the lender and the duration of the loan term.

While it is difficult to compare annuities to bonds, many experts say annuities are a better choice than bonds for generating income. This is because research shows they tend to outperform bonds in retirement portfolios.

A certificate of deposit (CD) is a special type of savings account offered by a bank or credit union with higher interest rates than traditional savings accounts. In exchange for receiving the interest, you agree not to access the account for a set amount of time.

CDs are considered a very safe investment because they are backed by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 for individual accounts. Like fixed annuities, CDs have a guaranteed rate of return and guarantee on the principal.

But comparing annuities to CDs is not apples-to-apples. Typically, CDs are seen as shorter-term investments, plus interest is taxed annually. Conversely, annuities are longer-term investments that offer tax-deferred growth.

Here is how fixed annuities compare with these two annuity alternatives.

A retirement income fund (RIF) is a mutual fund that takes a conservative investing approach. Typically, these funds hold both fixed-income securities and equities, and they prioritize consistency over growth. RIFs are sometimes referred to as managed payout funds.

Proponents of RIFs like their simplicity and all-in-one offerings. They are designed to produce regular payouts and have higher return potential than more conservative annuity alternative strategies like CDs or bonds.

However, because they are exposed to market risk, RIFs do not guarantee returns. Additionally, to meet your payout schedule, some fund managers may be allowed to access your principal.

Dividend-paying stocks are equity securities that distribute earnings regularly. They offer a fairly reliable source of passive income to investors, along with some growth potential.

Companies that offer dividends are usually well established, but FINRA says that stability comes with a trade-off. These companies are unlikely to “experience blockbuster growth,” and their shares are “less likely to see big jumps.” Even with this perceived stability, dividend-paying stocks do not guarantee returns.

That said, dividend-paying stocks exhibit much less volatility than growth stocks, and they perform relatively well during market downturns.

Variable and indexed annuities carry a higher risk than fixed annuities because a portion of their income stream is tied to market performance. Similarly, the most popular alternatives to variable or indexed annuities also provide a minimum guarantee with some upside potential.

Like an annuity, a variable life insurance policy is a contract with an insurance company that allows for tax-deferred growth. It is intended to provide income for your family or other beneficiaries upon your death.

Variable life insurance policies also have cash values that vary according to the policy’s fees and expenses, the premiums you pay and how that money performs in investment accounts (typically mutual funds).

The U.S. Securities and Exchange Commission cautions that the federal and state tax rules that apply to these insurance policies can be complicated. Because of this, it’s wise to consult a tax advisor before purchasing a policy.

As with any financial planning endeavor, consider all options before making any final decisions about the right savings strategy for you.

Most financial planning exercises do not entail “all-or-nothing decisions,” Milevsky says. “You don’t have to go ‘all in’ and can diversify across various products — that is some annuity, some not.”

For many people, the best solution might be a combination of several income-producing investments to meet financial goals and plan for a secure retirement.