People know Social Security will rarely provide enough income to live a comfortable retirement. Instead, you must find another way to save or invest to provide for yourself once you can no longer work.
Some people are lucky enough to have a pension to help cover retirement costs. The vast majority of Americans aren’t that fortunate, though. Instead, they have to figure out what to invest in to start building wealth.
One option you may be considering to help pay for your retirement is an annuity. They sound great on the surface, but the details of how they work may change your mind.
Even so, annuities are an option worth considering as long as you understand how they work and what you might be giving up. Here’s what you should know.
What’s Ahead:
What is an annuity?
An annuity is a contract between you and an insurance provider. The contract states that you’ll pay the annuity provider money now or over a series of payments. Then, the annuity provider will pay you either a lump sum or a series of payments at some point in the future.
As long as you hold up your end of the deal, an annuity can help you fund your retirement. Some people may opt to receive a lump sum at the beginning of retirement. However, the more common option is receiving a series of monthly or yearly payments from the annuity.
While the general idea of an annuity is simple and sounds enticing, the details make them much more complicated. You have several types of annuities to choose from and they all work in different ways. To make matters more complex, several fees normally come with annuities. Here’s what you should know.
What types of annuities exist and how do they work?
Annuities can be very simple or extremely complex. Ultimately, how your annuity works depends on how your specific annuity contract is written.
Sometimes, these annuities are tweaked in small ways to provide the desired outcome. There are a few major classes of annuities that cover most situations.
Many of these types of annuities may be combined. For instance, you may have an immediate, fixed, qualified annuity or a deferred, variable, non-qualified annuity. The following is not an exhaustive list of annuity options but should cover the most common situations.
Immediate annuities
An immediate annuity requires you to pay a lump sum of money to the annuity company today. In exchange, the annuity company will make a stream of regular payments to you starting immediately and going into the future.
Many salespeople try to sell these types of annuities when you retire. They want you to convert your retirement savings to an annuity to guarantee your retirement income. Be wary of this sales pitch. I’ll cover the fees associated with annuities in just a bit.
Deferred annuities
A deferred annuity is the opposite of an immediate annuity. You still pay money to an annuity company, and you may pay a lump sum or make payments to the company over time. The key is the payout is deferred until a date in the future.
This can help you get a larger annuity payout. The annuity company has time to invest the money you gave them which gives the money an opportunity to grow. How the money grows depends on the other aspects of your annuity.
Fixed annuities
Fixed annuities focus on the fact that your investment in the annuity will grow at a fixed rate. While you get a guaranteed rate of return on your money, that rate of return may not be as attractive as other options.
At the same time, that rate of return is guaranteed so you know exactly what to expect when you start receiving annuity payments. Fixed annuities may seem like they’ll provide enough income in retirement, but that may not always be the case.
Inflation can eat away at your future annuity payments over time. While receiving $1,000 per month may have seemed like an amazing deal 20 years ago, it isn’t as attractive today.
Variable annuities
Variable annuities do not provide a fixed rate of return. Instead, you typically get to choose what your annuity money is invested in with this option. These investments generally consist of mutual funds and other common investment options.
A variable annuity could allow your money within the instrument to grow even more than it could with a fixed annuity. It could also result in substandard returns depending on what you invest in.
Variable annuities don’t usually offer unlimited potential gains or losses. Your contract may limit your gain or loss potential. These limits can help you have more predictable returns and future annuity payments, but they come at a cost. Your contract may state the maximum gain in a year is 7%. If your investment within the annuity grows 10%, you don’t get the full gain.
Indexed annuities
Indexed annuities have performance tied to a particular index, such as the S&P 500 index. These types of annuities normally limit your risk by guaranteeing a minimum return of a certain amount. To take advantage of this benefit, the annuity doesn’t let you participate in the index’s full potential growth either. This limits your gains.
Qualified annuities
A qualified annuity simply means it is an annuity within a tax-advantaged account such as a 401(k) or IRA. This means the money contributed to the annuity was made before you paid taxes on it. When you eventually withdraw money from the annuity down the road, the funds will be treated as ordinary income which you’ll have to pay ordinary income tax rates on.
Non-qualified annuities
Non-qualified annuities are those purchased outside of a tax-advantaged plan. You can’t put pre-tax money into these annuities. You don’t pay taxes on the money as it grows within the annuity. You only pay tax on the earnings when you receive distributions from the annuities.
Common fees associated with annuities
While annuities may sound attractive, the fees that come with them generally make people realize they aren’t as good of a deal as they may have initially thought.
Commissions
If you get a lot of calls trying to sell you annuities, there is a reason. Annuities pay hefty commissions. Salespeople that sell annuities can get a big check if they can get you to contribute a considerable amount to an annuity. This commission increases the annuity provider’s costs and results in you keeping less of your money in the long run.
Administration or maintenance fees
The administrative or maintenance fee is standard with annuities. It may be a small percentage of your annuity’s value, such as 0.30% or less. In other cases, it may be a flat fee.
Mortality and expense risk charge
Insurance companies know that providing a guarantee could put them at financial risk. To offset this risk, they charge a mortality and expense risk charge. These fees typically are about 1.25%, more than an in-person fiduciary financial advisor charges in most cases. It’s also much higher than robo-advisors, which may only charge 0.25% annually to invest your money.
Fees on investments within the annuity
If your annuity invests in a mutual fund or an index, your annuity pays the management fees for those investments. Some investments have higher expense ratios than others. It’s essential to know precisely what assets your annuity invests in and the costs associated with them.
Surrender charges
Often, people find out annuities aren’t the best fit for them after they purchase the contract. You may be able to withdraw your money from an annuity early, but you usually have to pay a surrender charge to do so. The fees are often highest early on in the life of your annuity and may decrease over time.
Benefits of investing in annuities
Annuities can provide benefits to some people based on their situation.
- May provide a stream of income for the rest of your life.
- May provide certainty to project future income.
- May limit potential losses while still allowing partial participation in gains.
- Annuities are tax-deferred.
Drawbacks of investing in annuities
There are many reasons annuities may not be a good fit for you.
- Fees could eat up a large portion of your investment.
- Your returns may be lower than you could get investing outside of an annuity.
- They have several options which makes them complex investments to choose from.
- Salespeople may earn large commissions so their advice may not be objective.
Who may be a good fit for annuities?
Annuities are often a good fit for people that don’t like risk. They feel comfortable knowing that they’ll get a set amount of income in the future based on the payments they’re required to make. This makes planning much easier despite the fact they may not receive the best return on their money.
Who should avoid investing in annuities?
People that don’t need absolute certainty in their life may benefit from investing on their own. They must be willing to take control of their financial situation. If they do, they may be able to outperform the returns an annuity could provide.
These people could even hire a financial advisor or a robo-advisor to help avoid common pitfalls, potentially at a lower cost than many annuities charge.
Where you can invest in annuities
You have several places you can invest in annuities if you’re interested in them. Most people end up buying annuities from local insurance salespeople or financial advisors. They aren’t your only option for buying annuities.
TD Ameritrade
Some brokerages, like TD Ameritrade, offer the ability to buy annuities through their platforms. You can’t pick an annuity in your online account, though. You have to call a TD Ameritrade advisor so they can help you find an annuity that fits your needs.
As always, carefully read the entire annuity contract to understand exactly how it works, including all fees, before you choose an annuity.
Other options if you don’t want to invest in annuities
If annuities aren’t for you, you should still invest for your future needs. Here are a couple of options you may want to check out.
Betterment
Betterment is a robo-advisor that can help you work toward your investing goals, including providing income in retirement. As a robo-advisor, they only charge a 0.25% advisory fee which is low compared to a traditional financial advisor (normally about 1%) and many annuities’ mortality and risk fees.
Betterment helps you build and maintain a portfolio that fits your specific situation. They’re also a fiduciary, which means they must always keep your best interest in mind. Betterment can even help optimize your investments to minimize their tax impact.
Summary
Annuities may have a place in certain people’s retirement plans. They provide relatively predictable income based on the terms of the annuity contract you sign. They help lower your risk but come with many fees that may reduce the amount of money you could have otherwise earned on your own.
People looking to invest in annuities typically consult an insurance salesperson or financial advisor to find an annuity, but you can also consult with the annuity experts at TD Ameritrade. If you’ve decided annuities aren’t for you, you can start investing with a robo-advisor, such as Betterment, or start investing on your own with an app like Robinhood.
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