Annuities spark plenty of debate between investors and financial advisors.
These retirement savings vehicles are insurance products, and, like any other financial instrument, they have advantages and disadvantages.
Annuities are contracts that offer income or growth benefits. Retirees or pre-retirees who are skittish about risking money in the stock market often turn to annuities to preserve principal, although growth may be limited.
Some advisors object to these products, often because an advisor who sells an annuity receives a commission, which is forbidden in fee-only financial planning. There’s genuine concern in the financial planning industry that some advisors put clients into annuities mainly for the commission when investing directly in the market would have been a better course of action.
The suitability of annuities depends on an individual’s or couple’s financial goals. Here are some pros and cons to be aware of.
[Related:What Does a $2 Million Annuity Pay Annually?]
Pros of Annuities
An annuity can be a versatile retirement planning tool that provides guaranteed income, tax-deferred growth and legal protections.
Guaranteed Income
A dependable source of income is one reason that investors turn to annuities. For example, a retiree might have living expenses of $6,000 a month, with income of $3,000 from Social Security and $1,000 from a pension.
“You might want to purchase an annuity that will provide that $2,000 a month guaranteed payment stream,” said Ryan Cravitz, president of Cravitz Financial & Insurance Solutions in Orange, California, in an email.
“This income stream can last as long as you live, or if married, it can last for as long as at least one of you live,” Cravitz said, adding that annuities’ guarantees are backed by insurance companies.
That’s a reason, he said, to shop around for a highly rated company and understand the applicable fees and surrender charges as well as how an annuity will function within your financial plan.
Safe Withdrawal Rates
Many advisors will reference what’s known as a safe withdrawal rate of 3% to 5% of an investor’s portfolio annually.
“Annuities are one of the best tools to maximize safe income and can have guaranteed withdrawal rates that are higher,” said Carman Kubanda, a certified financial planner at Innovative Wealth Building in Fort Worth, Texas, in an email.
Kubanda noted that several variables determine what rate is paid out. Those include the annuitant’s age and the amount of time before payouts begin.
Retirement savers may want to compare the available withdrawal rates of various annuities versus typical portfolio withdrawal rates.
Legal Protections
Annuities are often judgment-proof, meaning they can’t be used as a legal settlement or to pay off debts.
“In most states, most of the time, annuities cannot be seized by creditors,” said Dale Hershman, an author and principal at Sick Advisory Services in Boca Raton, Florida, in an email.
Often, funds in an annuity are off-limits regardless of their value.
“This is how O.J. Simpson wound up owing tens of millions to the Goldman family but still enjoyed an untouchable six-figure income during the last years of his life,” Hershman said.
He added that it’s very difficult to steal annuity funds, as sometimes happens when an unscrupulous relative or caregiver siphons money from an investment account.
Tax-Deferred Growth
A key feature of annuities is tax-deferred growth. Because earnings are not taxed until the annuitant makes a withdrawal, there’s more opportunity for compound growth.
This feature is particularly advantageous for retirement planning, as it helps maximize accumulated value before taxes are due.
The flexibility of annuities is also a valuable feature, Kubanda said.
“There are many different types of annuities designed for different purposes,” he said. Those include products designed for income, growth and accumulation, legacy or long-term care.
[READ: 10 Ways to Reduce Taxes on Your Retirement Savings.]
Cons of Annuities
Annuities offer retirement benefits but come with drawbacks like high fees, limited liquidity and opportunity costs. Investors should understand these risks before buying.
High Fees and Complexity
As with any investment, high fees erode the account owner’s return.
The fee amount can depend on the type of annuity. Variable annuities, which invest in securities and offer returns based on market performance, generally have higher fees than other types. “That is because the insurance company charges a fee, and then the subaccounts also charge fees,” Kubanda said.
Fixed annuities guarantee a set interest rate and regular, predictable income payments. Another type of product, a fixed-index annuity, links growth to a market index while protecting the principal.
Limited Liquidity
When you purchase an annuity, you’re locking up your money for a set period, often six to eight years but sometimes longer, in exchange for growth. Withdrawals before the specified term may trigger a surrender charge.
That makes annuities unsuitable for short-term cash needs.
“It is very important that you understand how the annuity fits into your specific situation and liquidity needs,” Kubanda said.
He added that most fixed index annuities offer a free withdrawal amount of about 10% or the ability to take a required minimum distribution if it’s an individual retirement account annuity.
[READ: How to Build a CD Ladder for Retirement]
Opportunity Costs
There’s a trade-off between locking money into an annuity versus pursuing other investments.
Say you decide to purchase an annuity for $100,000 to get account growth and guaranteed income at a later date.
If you’d put that money into the stock market instead, you might see higher returns, especially in strong market years. However, investing in the market also comes with more risk and no guaranteed income.
Making an Informed Decision
Annuities can serve a purpose in many retirement portfolios, but it’s imperative to understand how the advantages balance with the disadvantages.
“If the client shops around, asks the right questions and fully understands what she is getting, the pros can often outweigh the drawbacks,” Hershman said.
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Pros and Cons of Annuities originally appeared on usnews.com
Update 12/04/24: This story was published at an earlier date and has been updated with new information.
