- Annuities are insurance products that provide premium protection, ensuring the return on your initial investment.
- Premium protection stems from transferring investment risk to the insurance company.
- State guaranty associations protect your premium with limited coverage in the event the insurance company fails.
When Is an Annuity a Good Investment?
Annuities are technically insurance products, not investments. Unlike most other investment vehicles, the money you put into an annuity — the premium — is protected up to a certain amount. Your premium is backed by the insurance company that sold the annuity. State guaranty associations provide premium protection up to $250,000 or more in most states if the insurance company fails. The exact amount varies by state.
Your specific reason for buying an annuity will determine which type, if any, fits your investment strategy. To help illustrate, consider some of the most common characteristics of annuity investors. If you fall into one or more of the following groups, an annuity might be right for your portfolio.
How soon are you retiring?
What is your goal for purchasing an annuity?
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You Value Premium Protection
Annuities offer premium protection by guaranteeing the return of the initial investment, ensuring that you won’t lose your principal regardless of market fluctuations.
“At its basic level, an annuity is a type of investment vehicle backed by an insurance company,” Andrew Rosen, president of investment management firm Diversified LLC, told the Annuity.org Podcast. “So, any annuity out there always has a big insurance company backing, unlike an individual mutual fund, stock, bond or other things of that nature.”
It’s also important to understand that your annuity payment is backed by the issuer’s ability to pay it. Be sure you purchase an annuity from a reputable company that has good scores from credit rating agencies like Moody’s or AM Best.
You’re a Risk-Averse Investor
An annuity contract transfers the investment risk to the insurance company that sells the annuity. Though all investments have a risk, annuities tend to be lower than many other options. This makes annuities a popular option for risk-averse investors.
“When you’re dealing with an annuity, it is, for the most part, an insurance [product] — It’s a guaranteed product,” financial advisor Chip Stapleton told the Annuity.org Podcast. “So if you are a very risk-averse investor, having something like an annuity can provide you a lot of an escape from the stress of market volatility.”
When thinking about the question, “When is an annuity a good idea,” the first thought that comes to my mind is if an annuity will be suitable for the individual that I am trying to assist. Annuities are best suited for providing a guaranteed lifetime income, or guaranteed joint lifetime income that, unlike other asset classes, cannot be outlived. Annuities may also be suitable for the individual, if they see the value of removing volatility from a portion of their assets. If these are important considerations for the client, then I would have to say, for this individual, yes, an annuity will be a good idea.
You Need a Customizable Option
Annuities can be customized to fit your unique financial needs and preferences. These options include riders designed to deal with specific situations.
Inflation-adjusted annuities, for instance, provide protection against rising living costs by ensuring your income keeps pace with inflation. This customization allows you to create an annuity strategy that aligns with your specific goals, making them a versatile and adaptable investment choice for securing your financial future.
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You’re Seeking a Tax-Deferred Investment
With annuities, your earnings can grow without being taxed until you withdraw the money, usually after you retire. And unlike other retirement accounts, there’s no limit to how much you can invest in annuities.
You also don’t have to take money out of annuities when you turn 73, so you have more control over your money. Annuities also make it easier to pass on your money to your loved ones after you die.
Annuities Fit Your Growth Horizon
Your age and growth horizon affect whether an annuity is a good investment. This horizon is the time it takes to get to your financial goal. You have to consider the accumulation and distribution phases — the periods in which you build wealth and withdraw it from your annuity.
- Accumulation Phase: During your early career or wealth-building stages, annuities may not be the best choice. Traditional investments like stocks, bonds, and mutual funds often offer better growth potential.
- Distribution Phase: Approaching retirement — or when you need a reliable income — annuities come into play. Immediate annuities guarantee income, serving as a safety net while providing tax advantages for retirement planning.
Because annuities have lower growth rates than other investments, they are not well-suited for long growth horizons. As a result, most annuity buyers tend to be 45 years old or older. And people tend to start taking distributions from their annuities when they are 70 or older.
You Want To Diversify Your Portfolio
Because of their premium protection, annuities can help diversify a retirement portfolio with more risky investment options.
“In 2012, when I was nearing retirement, I realized that the bulk of my savings were in retirement accounts, and I decided to, for my own peace of mind, to put that somewhere safe rather than [seeking] big returns,” Chuck Burton, an annuity customer, told Annuity.org.
Fixed annuities, in particular, are not subject to market fluctuations that can quickly change the value of stocks, mutual funds or other investments. As a result, annuities can provide a steady return in the form of guaranteed lifetime income.
“I think the appeal of a certain guaranteed return had us looking at annuities, it was wanting to add that mix to our portfolio,” Ron Thompson, another retiree and annuity customer seeking stable returns, told us.
Pros and Cons of Annuities
It’s always a good idea to weigh the pros and cons of any investment and consider how those pros and cons relate to your specific situation. Each type of annuity is unique and has different advantages and disadvantages.
Common annuity pros and cons include:
- Low Investment Risk
Because your premium is protected, you face less risk of loss when investing in an annuity. The layers of premium protection provide a safety net for the money you put into annuities.
Additionally, most annuities are unaffected by market fluctuations that can cause losses with other investment vehicles.
- Lifetime Income
Most annuities offer lifetime payment guarantees as the return on your investment. This makes them an effective tool for reducing your longevity risk (the chance that you outlive your money).
Annuities “are one of the best ways to address longevity risk, which is the risk of outliving one’s money,” Ken Orenstein, FRC, told Annuity.org.
Although annuities often have a reputation for being complex, that isn’t always the case. Some annuities are quite simple and easy to understand. For example, with a single premium immediate annuity (SPIA), you pay a single lump-sum premium in exchange for a specific dollar amount of lifetime payments.
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Annuities are relatively illiquid. You may be unable to access your money as freely as other investment types.
- Modest Returns
Annuities are not likely to grow like equity investments, even if your contract has an investment component. In addition, your returns may be limited by contract terms and fees.
You’ll be subject to an additional 10% tax if you withdraw from an annuity before you turn 59 ½, according to the IRS. Your contract may also specify that you cannot access your money before a certain length of time.
- Lack of Inflation Protection
Lifetime payments normally do not adjust for inflation unless you purchase an additional rider that provides it. Meaning the value of that fixed dollar payment may drop significantly over time.
- Complex Contracts
The more complex your annuity contract is, the more confusing it can be. Consumers often don’t completely understand what they buy or own. Make sure you know what you’re getting if you decide to buy an annuity.
Annuity Characteristics vs. Other Similar Financial Products
To further help you decide if an annuity is the right choice for you, you can compare annuity characteristics with those of other financial vehicles like equity investments (for example, traditional stocks) and savings accounts.
If you want premium protection on your investment and prefer less risky, moderate returns over riskier but potentially higher returns with tax-deferred growth, an annuity may be a good investment option for you. If you are worried about outliving your savings and want a stable, guaranteed lifetime income, an annuity may also be a good investment for your needs.
These are only a few of the features you’ll need to prioritize before deciding whether an annuity is a good investment for you. Working with a trusted financial advisor can help you decide whether an annuity ultimately makes sense for your needs and goals.