Retirement should be a time when, at long last, you can enjoy the fruits of your decades of labor. However, for too many, retirement can be a time of anxiety—particularly in regard to finances. You may find yourself overwhelmed by surprise expenses and the sheer number of financial products and services available. You may ask yourself, Is there enough money in my 401(k)? What are the pros and cons of annuities? Are annuities a good long-term investment? What happens when I run out of money during retirement and I’m stuck with high medical or long-term care bills?
An annuity is a financial product offered by insurance companies to transfer some risk from the retiree to the insurance company for some sort of fee or performance trade-off. However, the wrong type of annuity can be an inefficient way to allocate one’s finances, which is why it’s important to understand the pros and cons of annuities to determine how they could (or whether they should) be a portion of your financial portfolio.
What is an annuity?
Most working people are familiar with Social Security and pensions, which accumulate during one’s career and are paid in installments to a retiree during retirement. You can think of an annuity as another guaranteed stream of income, only instead of coming from the government or an employer, it comes through an insurance company. An individual contributes to an annuity via a lump sum or regular payments, and after the annuity gains interest or accrues, the individual can begin collecting payments.
When put this way, an annuity sounds simple. In reality, however, annuities are far from simple. There are many different kinds of annuities that insurance companies offer with different fee and performance structures, distribution schedules, and numerous other variables involving deferments, payment intervals, and so forth. Understanding the pros and cons of annuities for retirees begins with having a working knowledge of the basic types.
Types of Annuities
- Fixed annuities: A fixed annuity, as with other types of fixed financial products, guarantees a minimum interest rate for money invested in an annuity.
- Variable annuities: A variable annuity ties one’s money to mutual funds or other types of investment funds. This means that sometimes the money in the variable annuity may grow faster than money in the fixed annuity and sometimes more slowly, depending on the performance of the investment fund.
- Indexed annuities: A type of variable annuity, an indexed annuity links one’s money to the performance of the S&P 500, Nasdaq, or another stock market index.
- Income rider: The above types of annuities describe the means by which an annuity grows during the accumulation period. An income rider is an optional benefit regarding the annuitization, or payout period. Through an income rider, you may guarantee payments for a lifetime.
Even this list barely scratches the surface of all the types of annuities that are available. For example, there are some annuities that issue payments immediately and others that require a deferment period. Some annuities can be set up with a death benefit, not unlike life insurance, while others may allow joint survivor payments, allowing a spouse to receive payments after your death. Insurance companies have come up with all sorts of options and add-ons to make annuities as attractive as possible and to suit a wide variety of circumstances.
What are the advantages of investing in annuities?
If you’re nearing retirement and haven’t yet looked into annuities, don’t worry—it’s not something you would necessarily find on a checklist of retirement must-dos, and depending on your financial picture, it might not be necessary. Once you have a broad idea of the pros and cons of annuities, you and your certified financial plannerTM professional can discuss whether you stand to benefit from them.
Pros of Annuities
- No medical requirements: Life insurance is a great way to ensure that surviving loved ones are taken care of after your death. However, insurers won’t issue life insurance plans to people who don’t satisfy medical requirements. An annuity with a death benefit, which comes with no such medical requirement, can be a suitable alternative in such cases.
- Guaranteed income for life: A financial planner can evaluate your finances near or at retirement to determine whether your money will last for the rest of your life. If you’re less than ten or so years away from retirement and judge there to be a gap in your finances, an annuity can be a great way to close that gap and ensure that you receive payments for the rest of your life, depending on the terms of the annuity.
- Low risk: A fixed annuity that guarantees a minimum interest rate is considered a very safe investment. Unless the insurance company that issues the annuity goes bankrupt, an annuity principal should remain protected, guaranteeing income for the investor for the agreed-upon period.
Are there cons of investing in an annuity?
When planning for retirement, it’s important to work with a certified financial plannerTM professional with broad expertise in both insurance and securities. If you only consult an insurance-licensed professional, you risk missing out on securities-based financial products and services that may better suit your circumstances. Focusing too narrowly on insurance solutions may also blind you to the very real disadvantages of annuities.
Cons of Annuities
- Potential for high fees: Though there are some insurers that make a real effort to keep fees down, a highly customized annuity that requires substantial management may incur high administrative fees.
- Low returns: Fixed annuities are considered safe in terms of investment, but that safety comes with relatively low returns. Even variable annuities tend to have lower returns than comparable securities investments due to cost of securing distribution options. An insurer is likely to cap gains on, say, an indexed annuity, leaving the investor with just 60 or 80 percent of what they might gain with a more straightforward index investment for the safety they receive in return.
- Time commitments: In an ideal world, you and your advisor would recognize the need for an annuity ten years before retirement. However, life is complicated, and things don’t always work out as planned. Depending on which type of annuity best suits your circumstances, you may find the time commitment required before you start receiving a payout to be inconvenient or incompatible with your lifestyle or financial plan.
- Illiquidity: Retirement is a time when many people are looking to liquidate their assets so they have more opportunities to enjoy their wealth. However, drawing more than the predetermined dispersal amount can incur further fees or reduce your lifetime income.
Are annuities a smart investment in 2022?
In many ways, the past few years have been a scary time for investors. Dramatic ups and downs in the stock market have created much uncertainty, with many risk-averse investors opting for reliable, low-risk options such as a fixed annuity. However, an annuity is only as good as the insurance company that issues it, and it could be that certain securities-based investment options are more lucrative—even if the stock market is more volatile than you might like.
Whether an annuity makes sense for you depends entirely on your risk/return tolerance, how much you have accumulated for retirement, and your cash flow needs. After going over the pros and cons of annuities with your certified financial plannerTM professional, you may discover that an annuity provides the financial security you need well into retirement.
When to consider an annuity
Generally speaking, a retirement annuity is not something you would consider in the early or middle stage of your career, as you might with a 401(k) or an individual retirement account (IRA). Rather, it’s something you might consider as you approach the end of your career and as your retirement finances take shape.
When you’re less than ten years or so out from retirement, it’s a good idea to reconvene with your financial planner, evaluate your financial situation together, model specific lifestyle and life span scenarios, and determine whether you have enough money to cover your expenses. Anticipated medical needs, travel plans, and lifestyle goals are just a few elements that could influence your finances. If you find that there’s a disconnect between the retirement you envision and your financial circumstances, your advisor may recommend the guaranteed income of an annuity.
Selecting the right annuity
As stated above, there are numerous types of annuities: hand-in-hand with determining whether an annuity is appropriate is determining which type of annuity will best suit your needs. This depends entirely on your financial picture, including your income sources and retirement expenses.
For example, if you already have money in high-risk investments, your financial planner may recommend diversifying your assets and playing it safe with a fixed annuity. Conversely, a variable annuity has the potential to yield additional gains, depending on how well the underlying investments perform.
Finally, there are countless other variables that can impact one’s finances, and there’s an annuity option or benefit, it seems, designed to address each one. A death benefit, for example, can provide loved ones with a financial safety net in the event of your death. If the intent is merely to ensure a death benefit, however, a life insurance policy is the more efficient option if you can medically qualify.
You’ve worked hard your entire career, and you deserve a retirement that’s as close to your dream scenario as your finances will allow. The truth is, it’s entirely possible that an annuity is not necessary and may even be a hindrance to your financial goals. Unfortunately, an insurance-licensed advisor may not always be up front about this. After all, that’s the only investment they are licensed to sell you.
That’s why it’s important to entrust important retirement matters to a certified financial plannerTM professional experienced in both the securities and insurance side of retirement planning. Only then can you understand the full realm of financial possibilities and settle on a customized solution.
Whether you’re merely dreaming of retirement or have already retired, North Texas Wealth Management can help you navigate all the financial investments and services available and offer you sound asset management advice. Our detailed process for onboarding clients involves what we call a 3D Assessment: an introductory experience designed to uncover the ultimate “why” driving your entire financial plan. It will provide you with an assessment score. Reach out today and find out your score.