Do Annuities Ever Make Sense in a Retirement Income Plan?
For many investors who are afraid of outliving their retirement savings, it is tempting to invest in an annuity for their retirement income. After all, insurance companies often offer promises of low-risk fund growth, then guaranteed income during your retirement.
The allure of low-risk growth and guaranteed income can be quite the draw—especially in times of market variability, as we’ve seen with the COVID-19 pandemic.
But are annuities a wise portion of your retirement investment strategy? Let’s take a look at what annuities are and why you should almost always look elsewhere.
What Is an Annuity?
It’s easy to see why some people find an annuity to be an attractive choice for a retirement plan. An annuity is an insurance product that pays out a set amount of income at regular intervals. Annuities also have the ability to build tax-deferred savings that offer some level of protection to the money in the annuity.
You contribute a lump sum or monthly amounts, which then become “annuitized” (or converted) into a stream of income. Some annuities pay out on one future date, but most pay distributions on a series of dates. Some annuities offer “fixed” rates of return, and others provide “variable,” or fluctuating, returns.
Annuity Salespeople Earn Commissions
The main reason investors are drawn to annuities is their reliable income stream. “Life expectancies are getting longer,” explains retirement consultant Denise Appleby. “With that comes an increased risk of outliving one’s retirement savings.”
And insurance salespeople are happy to capitalize on that worry of outliving one’s retirement savings. But they probably won’t tell you that in selling you an annuity, they often receive a large commission for your purchase.
Say you buy a commissioned annuity with $100,000 of your retirement savings and say the insurance agent may receive a commission between 4% and 10% of that. That means the agent who sold you on the “benefits” of the annuity is going to walk home with $4,000-$10,000 of that purchase price.
With such a conflict of interest, the salesperson probably isn’t giving you advice based on your best interest.
Annuities Don’t Belong in Your Retirement Plan
Annuities aren’t the ideal fix-all that insurance companies and some financial professionals promise. In fact, you’d almost always be better off investing directly in an index fund.
Annuities depend on the strength of an insurance company for their success—and if that company fails, you’re at the mercy of your state’s insurance backstop program. Also, annuities often come with high fees, internal fund costs, and hindrances on your payout level, such as participation rates and caps.
Participation rates: In an indexed annuity, a participation rate means that your insurance company credits a certain percentage of the index return to your account. For example, if the market gained 7% and your annuity’s participation rate was 70%, you’d receive a 4.9% return (70% of the market gain).
And if you happen to have an annuity during a market dip, participation rate rules mean that your investment isn’t likely to make back what it lost during the downturn. The limited rate allotted to your annuity will hinder its growth during a market upswing, as opposed to an index fund.
Annuity caps: Similarly, an annuity cap is a limit placed on the return of an investment over a specified period. For instance, if the market returned 7% but your annuity had a cap of 2%, you’d only receive your maximum 2% return rate. Meanwhile, an investment portfolio would have had no cap on its returns.
What’s more, if you needed to take your money out of the annuity for some reason, the insurance company may penalize you (and the IRS could tax you). If you want to cancel or “surrender” the annuity altogether, you could face some hefty charges and penalties. Make sure to read the fine print carefully, and consider asking a fiduciary financial advisor or attorney to read it as well.
Final Thoughts
Annuities can be tempting, but our Greenwood, CO financial planning firm has almost always found a superior alternative for our clients for long-term growth, income, and liquidity. An annuity’s income stream for life sounds wonderful, but the caps, charges, fees, and penalties associated with that income should make you think twice before you sign the contract’s dotted line.
Discuss your situation with a fee-only financial advisor. Schedule a complimentary discovery call.
This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.
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