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5 Things You Should Know About Annuities

Income for life is nice, but it comes at a price

paper cut out stick figure and a rolled up hundred dollar bill sheltered under a paper cut umbrella labeled annuity

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En español | Having some guaranteed retirement income is particularly attractive in today's world of financial uncertainty. If you know you have a check coming every month for the rest of your life, you can worry less about stock market volatility or outliving your savings. You may also have some regular income from Social Security but it may fall short of covering your bills. If you aren't lucky enough to have a pension, you may be considering an annuity to boost your guaranteed income. But there are several types of annuities with a wide range of fees, nuances and purposes. Some are more suitable for retirement income than others.

Here are five things you need to know before you buy one.

1. They're simple — and complicated.

The basic annuity is easy to understand: With a single-premium immediate annuity, you hand over a lump sum to an insurance company and you'll receive a set amount of guaranteed income for life, no matter how long you live. The payouts are based primarily on your age, your gender and the interest rates when you buy the annuity. For example, a 65-year-old man who invests $100,000 in an immediate annuity could get about $494 per month for life ($5,928 per year). A 65-year-old woman could get about $469 per month ($5,628 per year). Payouts are lower for women because they are likely to live longer than men do. (Note: These amounts are as of May 2020. They are examples only and rates are likely to change by the time you read this.)

Income annuities “can be useful for prospective retirees who lack meaningful streams of retirement income, like Social Security and pension, or for those whose tolerance for market risk is low enough to make them fearful of what has historically been the optimal inflation hedge — stocks,” says Tim Maurer, a certified financial planner and director of adviser development for Buckingham Wealth Partners.

Not all annuities are simple. They come in many varieties — variable, fixed, fixed-index, immediate and deferred. Income annuities provide guaranteed lifetime income, either now or in the future, while other types of annuities help defer taxes or provide protection from stock market losses. For most people other than the sophisticated, knowledgeable investor, these other types of annuities may not be suitable for retirement income. The rules, the fees and the role they can play in your financial plan can be very different.

2. They require a commitment.

With an income annuity, you can't access your lump sum again after you hand it over to the insurance company. You'll get the largest monthly payouts with a life-only annuity, which continues to pay during your lifetime, no matter how long you live. But there are two important factors to consider before you take this option. First, the payouts stop when you die — whether it's in two years or 30 years. If that 65-year-old man dies after year 2, he would have received only $11,856 in payouts. But if he lives to age 95, he'd receive $177,840 in payouts. And second, it covers only you. If your spouse survives you, he or she would get nothing.

The 65-year old man could get a version of the annuity that guarantees payouts will continue for at least 10 years, even if he dies before then, in return for lower payouts. Or he could get a joint annuity that continues to pay out for as long as either he or his wife lives, but the monthly payouts would be much lower — a 65-year-old couple who invests $100,000 in a joint-life annuity would receive $417 per month for their lives.

Because you can only access that money as a lifetime income stream and don't have the flexibility to take extra withdrawals, be careful before tying up too much of your savings in an income annuity. It's important to keep other money accessible for emergencies and other expenses.

Also, the annuity's fixed payout will lose purchasing power through time. Some companies offer annuities that adjust the payouts for inflation, but those payouts start out much lower. Instead, you can invest the rest of your money for the long-term to help keep up with inflation.

One strategy when deciding how much to invest in an immediate annuity is to add up your regular expenses in retirement, then subtract any guaranteed sources of income you already have (such as Social Security and any pension) and consider buying an immediate annuity to fill in all or part of the gap.

Because of today's low interest rates, payouts for income annuities purchased now are lower than they had been in the past. “While you may avoid market risk with fixed annuities, you're accepting interest-rate risk,” Maurer says.

For this reason, some people consider laddering annuities — investing some money in an annuity now, then later buying more that will pay out higher amounts of income. This strategy depends on two factors: first, that payouts will be higher when you're older. For example, a 65-year-old man who invests $50,000 in an immediate annuity could receive about $247 per month for life. A 70-year-old man who invests $50,000 could receive $286 per month, in part because his life expectancy is shorter. And second, that you might get even more if interest rates rise by then. However, laddering can be complex for many people, so you may wish to speak to an adviser before acting.

Another type of income annuity — a deferred-income annuity — lets you invest a lump sum now but payouts won't start until sometime in the future. If you're still alive by then, you'll get much more each month. For example, if the 65-year-old man invests $100,000 in a deferred-income annuity that pays out starting at age 80, he'll get $1,640 per month. But if he dies before then, he'll get nothing. He could get a version that guarantees he or his heirs will receive at least as much as he invested, in return for lower payouts of $1,270 per month.


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3. You need to know what you want.

Income annuities provide guaranteed lifetime income. But there are other types of annuities that are much more complicated and potentially much more expensive (see the next section). Most of them may be more appropriate for sophisticated investors. Among these types of annuities:

  • Deferred fixed annuities can offer to pay a guaranteed rate of return on your investment for a set period of time, and taxes on the amount that you earn above what you initially invested are deferred until you take withdrawals.
  • Variable annuities let you invest in mutual-fund-like accounts and the money also grows tax-deferred. However, a normal variable annuity also exposes you to the risk that your investments may lose value. These annuities are more an investment vehicle with tax benefits than a way to get guaranteed retirement income.

An income rider to a variable annuity guarantees, for an additional fee, that you'll receive at least a minimum income for the rest of your life, no matter what happens to your investments.

Income riders are complex. For example, a rider may guarantee that the amount on which your eventual withdrawals are based increases by 5 percent per year, or lock in the high point that your investments have reached, even if the value drops after that. You can then withdraw up to 5 percent of that amount each year for your lifetime — no matter what actually happens to the investments. But if you take all of your money out of a variable annuity with income guarantees, you'll only receive the actual investment value, not the higher benefit base from the guarantee.

These annuities are most attractive to people who want to (and can afford to) risk some of their money in the stock market but plan to retire within three to five years and worry about a downturn in the first few years of retirement. “If it's a bad first five years, it's really difficult for you to recover from it,” says Mark Cortazzo, a certified financial planner and founder of MACRO Consulting Group in Parsippany, N.J., who helps people compare variable annuities and other investment options.

  • Fixed-index annuities let you benefit from a portion of a stock-market index's gains but protect your investment if the index declines. They typically tie their performance to an index, such as the S&P 500, but don't provide dividends. If the investments grow, you will usually only get part of that increase, such as 80 percent of the index's price increase, or a maximum percentage increase such as 6 percent, even if the index grows by much more. But the amount that you invest may be guaranteed not to lose money.

4. Safety comes at a cost.

The fees for income annuities are embedded in the payouts, and the safety comes at a cost because you can't access your principal in a lump sum after you hand it over to the insurance company.

The fees for variable annuities are spelled out in the prospectus, and while they may have advantages, they can be expensive compared with other types of investments. The average fees for variable annuities without additional features were 2.211 percent in 2019, according to Morningstar. Adding an income rider brings the average cost to 3.2 percent. This can be as much as two to three times what a 401(k) plan investor might pay.

However, some companies offer lower-cost annuities, such as one that charges just 0.25 percent for initial investments of $10,000 or more (or 0.10 percent for contracts of $1 million or greater) and has no surrender charges, but doesn't include an income guarantee. If this type of investment interests you, it is worth shopping around for the best deal.

Fixed-index annuities don't have fees spelled out separately; they're built into the structure of the product. For example, you usually don't receive dividends from the index and may receive only a portion of its gains. “Their performance is more like bonds than stocks,” Maurer says.

And both types of annuities can have hefty surrender charges if you want to withdraw the money you invested in them during the early years. For example, you'll typically have to pay a surrender charge of 7 percent if you cash out the annuity in the first seven years, with the charge gradually decreasing each year you own the investment. “Some fixed-index annuities have longer and higher surrender charges,” says Patrick Carney, a certified financial planner with Rodgers & Associates in Lancaster, Pa.

5. The seller — and the salesperson — matter.

Monthly payouts for income annuities (the kind discussed at the beginning of this article) can vary a lot by company, so it helps to work with a broker or adviser who deals with several insurers and can show you the best rates for your age and type of payout. In addition, a number of comparison websites can provide price quotes from several insurers for immediate and deferred-income annuities.

Since you're counting on the income to continue for the rest of your life, look for an insurer with a financial-strength rating of A or better, Carney recommends. Several providers, including Fitch, A.M. Best, Moody's and Standard & Poor's, rate insurance companies’ financial strength. Their ratings can be found online.

Variable annuities are not as easy to compare. The investments and fees can vary significantly, and it gets much more complicated when analyzing income benefit riders. Fees are based on terms that may be defined differently from company to company. Companies may also differ on how investment gains are measured and how often measurements are made.

Fixed-index annuities can be even more complicated. Performance can be based on different indexes and limited by complex participation rate calculations or caps. In all cases, if you don't understand exactly what you are paying for, ask questions or consider a different type of investment.

"Annuities have historically offered some of the highest commissions for salespeople,” Maurer says. In other words, some advisers have every incentive to sell you a product regardless of whether it best suits your needs. You may only be getting part of the story if you work with a salesperson who only sells annuities and doesn't explain your alternatives.

Finally, if you already have an annuity and discover it might be too expensive or not the right fit for you, you need to be careful before cashing it out — you could end up with a big tax bill or surrender charges, and you may lose an income guarantee you had locked in. Make sure that you understand the potential cost and your alternatives before acting.

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