If You Hate Annuities, You May Not Understand Them

No investment or insurance strategy is more polarizing than annuities.

SEE ALSO: All Annuities Are Not Equal: Do Your Homework Before You Bash Or Buy

Some financial professionals love them. Some hate them. Others claim to hate them — but only certain kinds. All of which is extremely confusing for the average investor.

The bottom line is that annuities can be a wonderful tool for those looking to generate guaranteed retirement income. They also can be a real headache if used improperly or if you’re sold one as a stand-alone solution rather than as part of an overall investment plan. Plus, they can be complicated. The contracts can be dense, inflexible and littered with legalese.

Types of Annuities

To add to the complexity, there are several types of annuities, each with its own pros and cons, depending on an investor’s specific needs. They include:

Immediate annuities: In exchange for a lump sum payment (or premium), an insurance company promises to immediately begin making regular income payments to you for a chosen length of time (usually five years to life). The amount of your payment will vary based on your age, gender and the length of the term selected. When you annuitize, you are giving up the principal and only have rights to the future income.

Fixed annuities: These are a lot like a certificate of deposit (CD) in that you give an insurance company a lump sum of money, and they offer you a fixed rate of return over the agreed-upon time period. Like a CD, if you need to make an early withdrawal during that time, there could be a penalty.

Variable annuities: These are often described as mutual funds wrapped in an annuity contract and purchased through an insurance company. The investment options are referred to as “subaccounts,” and just as when you invest in your 401(k) or brokerage account, you can choose to be aggressive, moderate or conservative. Your account value benefits from the upside of the markets, but it also is vulnerable to market losses.

Fixed index annuities or equity index annuities: These “hybrid” annuities act almost as a combination of fixed and variable annuities. They have the principal protection of a fixed annuity but also some upside potential because of their ability to earn interest based on the performance of the index to which they’re linked, such as the S&P 500.

Obviously, these are very brief descriptions. If you are truly interested in evaluating what an annuity could do for you, you’ll benefit from some research into specific products and an in-depth conversation with a financial professional before making a purchase.

See Also: 6 Options to Fund Long-Term Care in Retirement

3 Tips When Considering Annuities

Here are three things to keep in mind as you move forward:

1. Know the costs. Annuities have all sorts of customization options or “riders” that can be attached to a contract to expand or restrict a policy’s benefits. These can guarantee a lifetime income without having to annuitize, add long-term care features, enhance the death benefit and much more. These options almost always come at a price — and that’s on top of the base contract costs. They can add up, especially for a variable annuity, which typically has subaccount fees, administrative costs and mortality costs built into the base policy.
2. Understand the timeline. It’s never wise to put funds for shorter-term needs into an annuity. Make sure you maintain adequate liquidity to deal with daily and unexpected expenses, as annuities typically charge hefty penalties for violating early withdrawal terms. Also, be aware of the liquidity provisions, as some annuities offer one free annual withdrawal, allowing you to take out a specified amount that isn’t subject to penalties.
3. Understand the risk and growth potential. You can’t expect to match market growth using fixed or fixed index annuities, and you can’t expect protection from market losses from a variable annuity. While a variable annuity can match market returns, fixed or fixed index annuities act more like a bond component of a retirement plan.

When you’re ready to speak to a professional about purchasing an annuity, it’s important to find an experienced, unbiased adviser licensed in both securities and insurance, preferably with a CERTIFIED FINANCIAL PLANNER™, Chartered Financial Consultant® or Chartered Life Underwriter® designation; who acts as a fiduciary; and who represents multiple insurance companies.

Annuities aren’t evil — they’re just another tool that may or may not fit within your financial plan. Because they’re complex, it’s easy to make mistakes. Proceed with caution and be sure you’re getting the best advice from someone you can trust.

See Also: 3 Common Money Myths You Probably Believe

Kim Franke-Folstad contributed to this article.

Richard W. Paul is the president of Richard Paul & Associates, LLC, and the author of "The Baby Boomers' Retirement Survival Guide: How to Navigate Through the Turbulent Times Ahead." He holds life and health insurance licenses in Michigan and Florida and is a Certified Financial Planner, Registered Financial Consultant, Investment Adviser Representative and insurance professional.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.