retirement

If You Hate Annuities, You May Not Understand Them

Three tips to help you avoid making an annuity mistake.

No investment or insurance strategy is more polarizing than annuities.

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.

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.

Kim Franke-Folstad contributed to this article.

About the Author

Richard W. Paul, CFP, RFC, Investment Adviser

President, Richard Paul and Associates, LLC

Richard W. Paul is the president of Richard W. 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.

Most Popular

5 Ways to Prepare for a Recession
recession

5 Ways to Prepare for a Recession

The signs seem to be pointing in one direction these days, so if you’re worried about being ready for a recession, consider taking these five measures…
June 28, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
In What Order Should You Tap Your Retirement Funds?
retirement planning

In What Order Should You Tap Your Retirement Funds?

Should you go with your IRA first or your brokerage account? Pulling money haphazardly can have negative implications. Instead follow this road map fo…
June 28, 2022

Recommended

How 13 Types of Retirement Income Get Taxed
retirement

How 13 Types of Retirement Income Get Taxed

When you're planning for retirement, it's fun to contemplate all the travel and rounds of golf ahead of you, but don't forget about taxes.
June 30, 2022
In What Order Should You Tap Your Retirement Funds?
retirement planning

In What Order Should You Tap Your Retirement Funds?

Should you go with your IRA first or your brokerage account? Pulling money haphazardly can have negative implications. Instead follow this road map fo…
June 28, 2022
An Easy Way to Find How Much You Will Spend in Retirement
retirement planning

An Easy Way to Find How Much You Will Spend in Retirement

One simple math equation can help you determine where to start building your retirement income plan, and whether your money should last.
June 27, 2022
Retirement Comfort: How to Avoid Running Out of Money
retirement planning

Retirement Comfort: How to Avoid Running Out of Money

When it comes to retirement planning, one thing all of us worry about is whether we will have enough money to last. Financial professionals can help y…
June 25, 2022