Offered by insurance companies, an annuity is a financial product that can help you meet your retirement goals. Once you purchase the annuity contract, you’ll receive interest credits and the option for a guaranteed income stream, either immediately or later. While annuities are a powerful tool for retirement, there are many misconceptions about them. Below, we’ll debunk several of the most common annuity myths so you can make the most informed decision for your unique situation.
Annuities Are Bad
Contrary to some media coverage, annuities are popular products, just like 401(k)s, IRAs, and pension plans for many retirees. They are issued by insurance carriers and are distributed by reputable agencies, banks, or brokerage firms with longstanding histories in the insurance and annuity industry. These products are also regulated by state insurance commissioners and/or the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).
Annuities Have Hidden Fees That Make Them a Bad Deal
As with most financial products, annuities do come with some fees. However, annuity providers usually disclose them right off the bat so that you know exactly what they are before you move forward with the contract. The most common annuity fees include:
- Surrender charges: Surrender charges may apply if you withdraw funds before the annuity contract matures, usually between five to 10 years. The surrender charge period is determined at the time of purchase depending on the carrier and product selected.
- Administrative fees: These fees are usually a flat amount or a percentage of your account value charged for managing your annuity. They do not typically exist on fixed annuities.
- Agent commissions: While commission-free annuities do exist, some annuities come with agent commissions that typically range from 1% to 8%. However, traditionally these commissions are paid by the insurance carrier to the agent, and they do not come out of your account value.
- Investment fees: Variable annuities may be subject to investment fees between 0.6% to over 3% to help pay for managing the investments in your account.
- Mortality and expense (M&E) risk fees: These fees are typically about 1.25% each year and are intended to cover the insurance company’s risk of you selling the annuity. Typically, these do not exist on fixed annuities.
- Optional Rider Fees: Depending on the product purchased, there may be optional riders available for a fee. Those could include a higher premium bonus, a lifetime income benefit rider (LIBR), or long-term care benefits for example. These fees could range from 0.50% to 1.50% per rider selected.
Worried About Your Retirement Savings?
You Lose Access To Your Money Forever
Even though annuities are long-term vehicles, you may still access a portion of your funds. Fortunately, most annuities include a penalty-free withdrawal, typically 10% per year, that can allow you to pull money from your account before it matures without incurring any fees. As soon as your annuity is past the surrender period (usually five to 10 years), you may access the full value of your account and won’t have to worry about any penalties. In addition, you may choose a payout option that allows you to collect income for life, similar to a pension.
Annuity Payments Don’t Keep Up With Inflation
Inflation is important to consider when you plan for your retirement income. Many times, as an electable feature on a contract, with an inflation-protected annuity (IPA), you can shield your income benefit payments from the negative effects of inflation. An IPA uses the Consumer Price Index (CPI) to guarantee a rate of return that either meets or exceeds the inflation rate, protecting you from the rising prices for goods and services. Note that IPAs usually come with a cap, which is the maximum annual rate of return they can earn.
Insurance Companies Can Go Bankrupt, and You Lose Everything
Insurance companies are among the most highly regulated financial institutions, designed with safeguards to ensure policyholder protection. They are required to maintain strong financial reserves and adhere to strict solvency regulations set by state insurance departments. Additionally, most insurers are backed by state guaranty associations, which provide an added layer of security in the rare event of insolvency. Unlike banks, which operate on a fractional reserve system, insurance companies must hold enough assets to cover future claims, making them financially stable even during economic downturns. As a result, the risk of a well-established insurance company failing is extremely low, and policyholders can feel confident in the long-term security of their annuities and life insurance products.
Annuities Are Only for Retires
While many people associate annuities with retirees, these financial products can also be worthwhile for younger individuals and those who are still in their working years as they may benefit from deferred payouts or the guarantees and protection they can provide to your principal. Also, keep in mind that the earlier you open an annuity, the more you can take advantage of tax-deferred growth. Depending on your unique situation, annuities may be a smart way to diversify your retirement savings.
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Types of Annuities and Their Benefits
Annuities are not created equal. There are several annuity products to accommodate varying investor goals and risk tolerances. Here’s an overview of the most common types of annuities:
- Fixed annuities: Fixed annuities offer predictable, stable returns with guaranteed interest rates. These are known as one of the most reliable, low-risk options.
- Variable annuities: Variable annuities allow you to allocate your funds into investment options such as subaccounts that function similarly to mutual funds, typically holding stocks, bonds, or other assets. Your returns are directly tied to the performance of these underlying investments, meaning there is potential for higher growth but also the risk of losses, including a reduction in principal.
- Indexed annuities: Indexed annuities offer the potential for growth based on the performance of a market index, such as the S&P 500, while also providing downside protection. They can be thought of as a hybrid between a fixed annuity and a variable annuity.
Annuities may also be immediate and distribute payments right after you buy them or deferred and start paying you at a later, predetermined date. In addition, these products can be qualified and funded with pre-tax funds and subject to regular income tax or non-qualified and funded with after-tax money.
Key Features and Benefits
The most noteworthy benefit of annuities is their ability to provide guaranteed income for life. With annuities, you can reduce the risk and fear of outliving your retirement savings. You may find it easier to budget for your expenses and lead life to the fullest once you leave the workforce.
Annuity offerings from carriers are diverse and sometimes specialized to a specific need or niche, making it easy to find a product that caters to your particular goals, preferences, and risk tolerance. You can choose to receive your payouts in a lump sum or periodically throughout your lifetime. If you have a spouse, you might also opt for joint annuity payments, which guarantee the surviving spouse will continue to receive payments after one partner passes away.
Lastly, annuity contributions can be tax-deferred and grow tax-free until you withdraw the funds. If you decide to purchase an annuity when you’re still working and earning money, this may lead to significant tax benefits. While your payments will be taxable, you’ll likely be in a lower tax bracket when you retire.
Fees, Charges, and Risks
There is no perfect investment and like all financial vehicles, annuities do come with a few drawbacks that are essential to understand. First and foremost, make sure you understand any fees and surrender charges. If you opt for variable annuities, you may also owe investment fees and lose money if your investment performs poorly. Additionally, most annuities have stipulations on when you can withdraw the money. You’ll likely face a surrender fee if you pull all your funds from your account before the initial surrender period.
Still Not Sure Where to Begin?
Financial Strength and Consumer Protection
Before you sign on the dotted line with any financial product, including an annuity, it’s in your best interest to assess financial strength and consumer protection. Take the time to research the financial strength ratings of the annuity providers you’re considering. Reputable organizations, such as A.M. Best, Moody’s, and Standard & Poor evaluate insurers with ratings that can inform you of how likely they are to follow through with an annuity contract and provide you with the payouts you’re entitled to. In addition to financial strength ratings, you may want to explore customer reviews to gain insights into what current and future policyholders have to say about an insurance company’s service, payouts, and transparency. We also suggest you consult the expertise of a licensed insurance agent to review your goals and needs to determine the potential right solution for your unique situation.
Is An Annuity Right for You?
Annuities are usually worthwhile for those who want to reap the benefits of predictable income streams and tax-deferred growth, and principal protection with a fixed or indexed annuity. However, whether an annuity is a smart solution for you depends on several factors, including your age, risk tolerance, retirement goals, and other income sources. You can always consult an experienced financial professional who can thoroughly evaluate your situation and steer you in the right direction. If you decide that annuities are a good fit, however, be sure to shop around and compare all of the options available.
