The fear of running out of money consistently ranks as a top concern for retirees and soon-to-be retirees. And yet, despite their anxiety, many people I talk to have never considered using an annuity — which can provide a reliable income stream in retirement — as part of their income plan.
I get it. Annuities have gotten a lot of criticism through the years. (Some deserved, but often not.) The contracts can be complex, the fees can get expensive, and they’re less liquid than stocks or bonds. Often, the negative information you see about annuities is dated or just wrong. And it can take time and effort to understand the many different types of annuities that are available.
But for those who are looking for predictable income that lasts for a fixed number of years or as long as they live, an annuity can be a solid strategy, worth researching and/or discussing with a financial adviser.
How do annuities work?
Did I mention that annuities can be complicated? Here are some of the basics:
An annuity is an insurance contract that guarantees future income payments in exchange for money paid upfront in a lump sum or over a period of time. The company that issues the annuity will calculate the amount of your payments based on how much you contributed and how long you want your payments to continue.
The three types of annuities you’ve probably heard about the most are fixed, variable and fixed-index annuities.
- With a fixed annuity, the insurance company guarantees you’ll earn a specific minimum interest rate on your money, paid out over a fixed term or as a lump sum.
- A variable annuity’s value is based on the performance of a basket of investments or “subaccounts” you choose, including stocks, bonds and other options. The amount the annuity pays out to you will depend on how those investments perform. Keep in mind you are participating in the market, and there are typically fees involved that may range from 2% to as high as 4%, from what we have seen.
- A fixed-index annuity is sort of a mix of the two. Returns are tied to the performance of a specific stock market index (like the S&P 500 or Nasdaq). But because your money is never directly exposed to the stock market, the principal is protected against market losses. However, there also can be a limit on your annual return.
There’s no “right” choice here — it’s all about finding the best fit for you. Each annuity type has pros and cons, depending on the investor’s needs. But the upside they share is that each can allow you to stash away cash for retirement and defer paying taxes. You can watch your money compound for years, if you like, without a tax bill.
When choosing your best annuity option, it often comes down to how you feel about protecting your money. Remember: The return earned by a variable annuity isn’t guaranteed. If the value of the subaccounts you choose goes up, you can make money. But if the value of those subaccounts goes down, you could lose it.
Which is why, when I talk about annuities with people who are looking to further fortify their reliable retirement income, I mostly focus on fixed-index annuities and fixed annuities — and, in the latter category, multiyear guaranteed annuities (MYGAs).
Why a MYGA?
Technically, a MYGA is a type of fixed annuity. But while a traditional fixed annuity contract may guarantee only the initial specified rate of return for a portion of the annuity’s duration, a MYGA guarantees that rate for the entirety of its term.
For example, if you purchase a five-year MYGA, the guaranteed rate will stay the same for the full five years of the contract. With a traditional fixed annuity, the guaranteed rate may be effective only for the first year or first few years of the contract — and then the rate may be adjusted.
Right now, because interest rates are up, you can use a MYGA to lock in a higher rate than investors have seen in years. You can let your money sit for the duration of the term — usually three to 10 years –– earning that rate for the entire time and accumulating more money for your retirement goals. When the term is over, you can decide where to go with that money next. (You may choose to begin regular payouts, or you may decide to invest in another MYGA or a different type of annuity or investment. That choice will be up to you.)
If you think interest rates will continue to rise, you may not want to lock into one rate for several years with a MYGA — and a traditional fixed annuity or fixed-index annuity might be a better choice. On the other hand, if you believe we’ve hit a high with interest rates, a MYGA may be the right investment for you.
Obviously, it’s a lot to think about. And regardless of which type of annuity you choose, you’ll want to be cautious. Here are things to consider:
- Always read the contract. MYGA and fixed annuity contracts are the most straightforward of the bunch. Still, you’ll want to find out all you can about any annuity’s surrender period, fees, riders, etc. If you can’t understand what you’re reading, don’t hesitate to ask for help from an experienced financial adviser.
- Know the risks before you invest. When you see the word “guaranteed,” make sure you know what that means. Are there limits on how much you can earn, and more important, how much you can lose?
- Compare the different annuity options to similar investment alternatives. Would you be better off investing in CDs, life insurance or bonds? Again, this is something a financial adviser can help you figure out.
- Know yourself. Could having your money tied up in an annuity get in the way of other plans or goals?
- Know the carrier. Check out the insurance company that’s behind the annuity and keep an eye out for scams.
- Take it for a test run. In many states, you can cancel an annuity without losing your money or paying a penalty if you do so within a predetermined “free look” period.
Kim Franke-Folstad contributed to this article.
The appearances in Kiplinger were obtained through a public relations program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
Joseph Cervinka is vice president and co-founder of Kingsguard Capital where he specializes in all things retirement planning, including Medicare, income planning and investments. He is a dual-licensed fiduciary, and he is passionate about always working in the best interest of his clients. He hosts the radio show “Retirement Wars!” Saturday mornings on radio station WRVA 1140 in Virginia.
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