Last Updated: January 2021
Retirement is an exciting time in life, but it can also cause some stress for individuals who feel unprepared financially for the years ahead of them.
Part of this may be due to procrastination, and some of the anxiety can be due to not understanding how much money you may need in retirement and what the best methods may be for effectively managing a fixed income for the relaxing years in life.
Annuities are often considered for individuals entering these years of their life and with good reason. If you understand what to watch for in addition to the pros and cons of annuities, they can be a viable addition to your portfolio.
In this article, we will cover the pros and cons of annuities and what pitfalls, if any, to avoid when searching for the best annuity for your specific financial situation.
- What is an Annuity?
- What are Variable Annuities?
- Pros and Cons of Variable Annuities
- What are Fixed Annuities?
- Pros and Cons of Fixed Annuities
- Learn More About Annuities Before Signing a Contract
What is an Annuity?
Before diving straight into the pros and cons of annuities, it seems more fitting to quickly explain what an annuity is to get everyone up to speed and on the same page.
For many, annuities can seem confusing and difficult to understand. An annuity is much like purchasing insurance contracts.
In exchange for money that you pay in and invest today in either lump-sum payments or payments over time, you will be provided the security of that money returned with interest in the future. Most commonly, during retirement years, when stable monthly income is needed the most.
Annuities Can Bring Peace of Mind
Annuities can provide peace of mind and allow you to have predictable income in your retirement years, allowing you to retire comfortably even after your primary sources of income have dried up.
The amount of money you can receive as a stream of income in your retirement years can vary significantly based on the kind of annuity you purchase, how soon you begin investing.
Most commonly, individuals will pick an annuity that can fall into two broad categories. More options for the kind of annuity you can purchase are available, but in general, those annuities can still be generalized into these two primary categories.
What are Variable Annuities?
Variable annuities are more complex than fixed annuities and are considered much more of an investment vehicle with more upside than fixed annuities. In exchange for the additional gain potential with variable annuities, you also take on more risk and have less certainty and peace of mind compared to fixed annuities.
Your future income will be determined based on your total amount of money invested and the performance of the markets that your annuity is funded within.
A typical example of where you may have your funds invested with variable annuities includes the S&P 500. Variable annuities are also known to have more fees than other annuities (more on this later).
Simply put, variable annuities provide you with a better chance of high returns and a better chance at battling inflation but do come with uncertainty and should be considered and evaluated with a professional.
Pros and Cons of Variable Annuities
Variable annuities have advantages and disadvantages. Let’s take a look at them here.
Pros of Variable Annuities
Annuities have some unique perks that individuals can take advantage of for their retirement years, depending on if you choose a fixed or variable annuity.
Here is an overview of the pros of variable annuities:
Variable annuities are often purchased before the ages of retirement, allowing investors to defer earnings during their working years, like how an IRA behaves.
Potential for More Earnings
Variable annuities are attractive due to their potential for higher earnings by investing in specific markets.
With inflation continuing to decimate fixed incomes across the US and retirement years becoming more difficult to financially plan for, the opportunity at higher returns on your investment is a benefit that can be tough to overlook.
Income Riders Can Provide Guarantees and Death Benefits
One of the downfalls of variable annuities is the fact that more risk is involved, and risk is especially more frightening when you’re attempting to plan a stable and predictable retirement. Income riders can help solve this issue.
Although fees are involved with this rider, you still can place an income rider on your annuity that will provide a guarantee % of income on your annuity regardless of the market conditions.
This also allows you to guarantee a lump sum death benefit to your family in the event you pass away before ever collecting any monthly income streams from your annuity.
If your style is to play the market and shoot for more substantial returns while still having some form of safety and guarantees, an income rider attached to your variable annuity might be your best solution.
Cons of Variable Annuities
On the flip side, variable annuities do have some negatives that need to be considered:
Higher Fees Built into the Annuity
Variable annuities have had a bad reputation in the past. Part of this is due to the fees that are associated with the purchase and management of the annuity, and agents lack of explanation that can take place at the time of purchase.
It is not uncommon for a variable annuity to have fees that equal 4% or more. This means that for every 100,000 invested, you could be paying 4,000 or more dollars just to remain invested and managed inside of the annuity itself.
These fees can include the following:
- Administrative Fees- .015% or Less
- Rider Fees (Refer Back to Guaranteed Income Riders)- Varies for Each Insurance Company
- Management Fees- 1.5% or Less
- Mortality and Expense Fees- 1.5% or Less
While you can shave some of these fees by not including the guaranteed income rider, 4% is still a sizeable chunk of expenses to be taken from an investment needed to provide income for life in your retirement years.
Surrender charges are one of the other most significant drawbacks of variable annuities. Surrender charges are also what makes it so imperative to thoroughly plan your financial future before locking into any contracts.
Annuities are designed to not withdraw early. Doing so can result in an early withdrawal fee of 10% or more in some situations. Carefully plan and ensure you are not strapping your monthly budget too tight before purchasing any form of an annuity.
What are Fixed Annuities?
Fixed annuities are much more black and white and do not come with the same level of anxiety and uncertainty as variable annuities. Fixed annuities also do not offer the same chance at higher returns.
In exchange for a lump sum of money or monthly investments, the insurance company will set a locked or guaranteed rate of return and provide a stream of income for your retirement years.
The interest rate or gains provided within fixed annuities is a locked rate set by the insurance company minus any fees. 3% is a standard rate of return for fixed annuity products.
Immediate Fixed Income or Deferred Income Options
Fixed annuities will allow you to either take immediate fixed income or defer the income until a later date in time determined by your contract with the insurance company. These annuities can be purchased to provide income until a certain age or until death, depending on the specific contract.
Most commonly, fixed annuities will begin immediately after purchase or with one year unless you opt for a deferred annuity. The annuity will continue to collect interest until the date you have specified to begin receiving your monthly income streams.
Now that we understand the basics of annuities in addition to the common types of annuities you can purchase, let’s dive into the pros of cons of purchasing annuities to supplement your retirement income.
Pros and Cons of Fixed Annuities
Fixed annuities have benefits and risks as well. Here are the pros and cons of fixed annuities:
Pros of Fixed Annuities
Fixed annuities also have some significant benefits you can take advantage of that include the following:
- Guaranteed contractual rate of returns providing peace of mind and easy planning when it comes to monthly income in your retirement years.
- Fixed annuities are a safe and efficient investment vehicle with little to no risk involved.
- Substantially Fewer Fees than Variable Annuities
- Another benefit of fixed annuities is the fees are dramatically lower.
You will not have any fees associated with the guaranteed income rider, and fixed annuities typically have no management and administrative fees.
More of the money invested in fixed annuities goes back into your pocket compared to variable annuities.
Cons of Fixed Annuities
On the flip side, fixed annuities do not come without drawbacks:
- Low rate of return
- Fixed annuities are not going to offer the upside you can experience with a variable annuity or investing in general.
- The insurance contract and guaranteed % or earnings or “rate of return “will typically fall in the 2-4% range.
- While this is certainly not a bad additional gain during retirement, it can begin to be tough for 2-4% to keep up with the cost of living.
Simply put, a fixed annuity may not be good enough, and it is typically advised that you have other investments complimenting your annuity instead of your annuity being your entire savings and retirement plan.
The same applies to fixed annuities. You should not invest in fixed annuities unless you are 100% sure you have the available funds ready for investment.
Early withdrawal or pinching yourself too tight on the budget can result in surrender charges of 10% or more.
Learn More About Annuities Before Signing a Contract
Annuities are an option to help provide worry-free income streams in retirement years.
The pros of each form of an annuity can outweigh the risks in many situations.
It is, however, imperative that you work with a professional to understand the fees associated with annuities, how surrender charges work, and if annuities are the best option for you.