Cash flow planning is often a significant challenge for many families throughout their careers and into retirement, and many retirees are understandably concerned about running out of money in their golden years.
This leaves some retirees turning to annuities, which provide a fixed income stream for life. While annuities sound attractive on their face, no financial product is without flaws, and annuities are the subject of much debate within the financial planning community.
Should it have a place in your financial plan?
What’s an Annuity?
An annuity is a financial product that pays out funds for a set period. Annuities are often used to help fund retirement since they protect against longevity risk in your golden years and can help to ensure that your retirement funds don’t run out early. While annuities sound complicated, you might be more familiar with them than you think. Social Security is technically a type of annuity, for example.
There are many different types of annuities available to consumers. The two overarching categories are fixed and variable annuities.
- Fixed annuities earn a guaranteed interest rate, making them a safe bet for conservative investors looking for a stable return.
Variable annuities are subject to market performance, so while there’s no guaranteed growth, they also offer the possibility of a higher return.
- Consumers can also choose between immediate annuities, where payouts start immediately, or deferred annuities, where payouts start at a future date.
How Annuities Work
Annuities are typically sold to consumers by insurance companies and other financial institutions. Consumers can fund an annuity either through a one-time lump sum or through regular payments during the accumulation phase.
You can choose whether you want to begin receiving payouts immediately, or whether you want to defer payments until a future date. Deferring payments can give your investment more time to grow. Once you begin to receive payments, your account has reached the annuitization phase.
How long payments from annuities last depends on the specific type of annuity. Some annuities guarantee a steady stream of lifetime payments, while other types of annuities only guarantee payments for a fixed length of time, such as twenty or thirty years.
How Are Annuities Taxed?
There are two types of annuities; qualified and non-qualified. Qualified annuities are funded by pre-tax contributions while non-qualified annuities are funded with after-tax dollars. Both allow for tax-deferred growth. When you receive distributions from your qualified annuity in retirement, these funds will be taxed as ordinary income. If you have an after-tax annuity, you only have to pay taxes on the earnings upon distribution, although prior to annuitization the earnings are considered to be distributed prior to your original after-tax investment in the contract. If you withdraw funds before a certain age or time period you may incur an additional penalty.
Advantages To Consider
Annuities are an attractive option for retirees for several reasons.
- Consistent income: First and foremost, annuities provide a consistent stream of cash in retirement and represent an income you can pretty much guarantee on.
- Reliable returns: Depending on the type of annuity you choose, you may be able to lock in a guaranteed rate of return, which can help with cash flow planning and ensure that you don’t outlive your assets.
- Taxes: Both qualified and non-qualified annuities are tax-deferred which allows for taxes on capital gains, dividends, and interest to be deferred until withdrawal.
For individuals who want a safe, stable source of income in retirement in addition to other sources of income from retirement accounts and Social Security, the right annuity could be a good option to include in your retirement portfolio.
Drawbacks To Consider
While there are some benefits to annuities, they also come with significant drawbacks that you should think through before investing in this type of asset.
- High account fees: Annuities come with high account and investment fees, which means that the rate of return is potentially much less than other retirement options.
- Surrender charges: If you withdraw funds during the surrender period, the designated amount of time an investor has to wait before withdrawing, you may also be subject to sky-high surrender charges (6-10%), which can further deplete your funds. Surrender periods are often convoluted and lengthy—the average is 6 years.
- Expensive riders: Many annuities allow you to add extra coverage for things like long-term care or death benefits. To take advantage of this, you’ll need to purchase additional riders which come with more sets of fees.
- Lack of liquidity: Annuities are also an illiquid investment. Once you place money in an annuity, it’s very difficult to access. With many annuities, what you gain in stability, you lose in terms of flexibility and quick access to cash. If you do decide to purchase an annuity, you should be sure that you also have liquid assets to turn to in the case of an emergency.
- High complexity. Another downside to annuities is their complexity. Annuities can be incredibly complex and difficult to understand for the average consumer.
- Large Commissions. Many annuities pay large commissions to the brokers and insurance agents who sell them. Due to this large financial incentive to the salesperson, annuities are commonly sold to consumers that they are inappropriate for.
Annuities are a large and complex financial product. Before signing, you should always discuss plans with a fee-only fiduciary advisor, whose commission isn’t on the line.
Customize Your Retirement Plan Today
Your advisor can help you decide if an annuity is right for you. Working with a trusted advisor can help you to weigh your options, come up with a financial plan, and diversify your investments to help make sure that your golden years are safe and secure.
If you’re nearing retirement and need help with your financial plan, we’d love to help. Get in touch with us today!