Investing In Annuities

Pros and Cons of Buying Annuities

Investing In Annuities
January 2, 2014

An annuity is an insurance product and retirement planning tool that establishes a future income stream based on a current investment. Most annuities are sold through insurance companies, but some are supplied via direct sale from investment companies such as Vanguard and T. Rowe Price.

You have two choices regarding the style of annuity:

  • Deferred vs. Immediate - This refers to when payments begin. Younger buyers would probably benefit more from a deferred annuity, so the value can increase and provide larger payments at retirement; those nearing retirement may prefer an immediate annuity. Deferred annuities may be converted into immediate annuities should cash flow become a problem — however, there may be fees or penalties associated with early withdrawal.

  • Fixed vs. Variable - This refers to the payout method. Payouts can be a fixed amount, or be varied through market and investment performance. Under a fixed rate plan, the insurance company chooses the investment vehicle, but you have some choices under a variable plan. Hybrid plans, mixing fixed and variable elements, are also available.

Typical payout options are:

  • Period-certain - The payment amount is guaranteed for a fixed period. Your beneficiary receives the remaining payments if you die during this period.

  • Lifetime Payment - Guaranteed income only during your lifetime. These may be fixed or variable payouts, but once you die, the payments end. There are no beneficiaries or payments to heirs.

  • Life with Period-certain - A hybrid of the above that provides lifetime payments, but for a particular period of time allows beneficiary payments. For example, if you die seven years into a ten-year period-certain arrangement, your beneficiary receives payment for the remaining three years.

  • Joint and Survivor - The recipient continues to receive payments after your death for as long as they live — ideal for couples planning to tie the knot or already married.

Why would an annuity be attractive? Primarily for tax purposes — annuities provide tax-deferred growth, and they do not have yearly contribution limits as IRA's and 401(k) programs do. This allows you to put a substantial amount of money away for retirement that provides tax-free growth — which is particularly appealing if you are approaching retirement age and your stocks and other investments took a dive because of the recession.

The potential cons of annuities are the same as with many investments — costs and investment risks. If you are purchasing an annuity through an insurance broker or agent, there is likely to be a significant commission involved. Annual expenses for investment management and other administrative functions can be high, and theoretically could cancel out the growth of the annuity. Penalties are generally charged for early withdrawal with respect to the purchase date (typically 7% of value in first year, gradually decreasing to zero) and with respect to your age (withdrawals prior to 59-1/2 are penalized similar to IRA's and 401(k)'s).

An annuity makes the most sense if you have enough cash on-hand -- and low enough debt -- that you can afford not to access it for a significant number of years. With less cash on-hand, an IRA, 401(k), or other tax-friendly vehicle might be preferable. As with any investment, be sure to assess all the fees and charges. Also, in considering your options, remember that your earnings are still taxed on withdrawal at your ordinary income tax rate, even though your original investment is not.

If you do buy an annuity, make sure it is issued by a strong insurance carrier that will still be around when you require payments. Otherwise, you will have limited recourse to recover your money if the company fails.

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