Is an Annuity a Smart Choice? Here’s What They Cost You

what is an annuity

When it comes to planning for retirement, the goal is often to find a reliable source of income. You want to be sure you will have enough money to live comfortably.

This desire for reliable income is one of the reasons annuities are popular in some circles. Even though some annuities can be complicated and expensive, they are attractive because they offer guaranteed income during retirement.

But what is an annuity, and how do annuities work? Here’s what you need to know about this retirement strategy.

What is an annuity?

At its most basic, an annuity is a contract between you and an insurance company. You agree to provide a certain amount of money, and the insurance company promises to invest that money and pay you regularly.

In theory, you receive a steady stream of income during your retirement. Depending on the annuity, you may receive the income for a set period of time or you can receive it indefinitely. It’s no surprise that some retirees like to put at least a portion of their retirement savings toward an annuity.

How do annuities work?

There are two ways to fund an annuity. You can either deposit one large lump sum, or you can invest smaller increments over time.

Your monthly payout depends on how much money you’ve put into the annuity, along with how long you are expected to receive payouts.

You can get a bigger payment each month if you agree to a definite term, such as 10 years or 20 years. However, if you’re afraid of outliving your money, it may make sense to take a smaller payout until you pass away.

Annuities aren’t right for everyone, and things can get complicated once you start reading the contract. Generally, an annuity should be only one part of a larger retirement plan.

Fees and charges can make annuities expensive and complex. Because the income is guaranteed, you probably won’t earn a large return on your money. Plus, there can be issues after you die; some annuities won’t continue paying out to your partner or heirs.

Types of annuities

Answering the question, “What is an annuity?” isn’t as straightforward as you think. There are different types of annuities, each with their own benefits and drawbacks.

Before you choose one, it’s important to consider your needs and consult with a financial planning professional.

Immediate annuity

This is one of the most popular types of annuities. With an immediate annuity, you pay a lump sum and usually begin receiving payments 30 days after you’ve invested your money.

What you are paid depends on your age, how much money you put in, and whether you’ve defined a specific payment period.

One of the ways a retiree can fund an immediate annuity is to take a portion of their 401k or IRA and use it to purchase the contract. In many cases, the annuity payout is used to fund basic living expenses that aren’t covered by Social Security.

It’s rarely a good idea to liquidate your entire nest egg to fund an annuity, though. One rule of thumb is to use no more than 25 to 30 percent of your retirement portfolio for an annuity.

Deferred annuity

Rather than purchasing a contract that pays immediately, you can choose to contribute money over time. You agree to put in a set amount of money each month for a number of years. When you’re ready for the money, you convert those deposits into an income stream.

What you end up with depends on how much you put in each month, how long you contribute, and the earnings on your contributions. In general, your annualized return will be quite low. For many people, an annuity is not the best way to build up enough wealth to completely fund retirement.

Fixed annuity

Annuities involve a return. With a fixed annuity, the insurance company promises a minimum interest return. In some cases, the insurance company pays a higher rate for one to five years before dropping back to the minimum.

Understand that your return won’t change with inflation. If you receive payments indefinitely and live for another 20 or 30 years, your money won’t retain its value. This is one of the reasons it’s important to keep the bulk of your retirement portfolio in assets with higher potential returns.

Variable annuity

If you’re hoping for a little more yield, a variable annuity can offer a boost.

Instead of having a guaranteed rate of return, your returns are based on investments in sub-accounts. The choices are preselected and your returns fluctuate. This means you might not be able to rely on your returns, and big drops can impact your annuity.

You can rebalance your portfolio without immediate taxation concerns because taxes on your earnings are deferred until you start withdrawing from the annuity.

Indexed annuity

An indexed annuity offers you the best of both worlds. You often see a guaranteed minimum, but it’s also tied to an index like the S&P 500. This means you can see higher returns based on the performance of the index.

This doesn’t mean that you end up with the same returns as the index, though. Most indexed annuities cap your returns, but your returns can still potentially be higher than you’d see with a fixed annuity, and you are protected from the downsides of variable annuities.

Annuity costs

Fees are a reality no matter how you decide to invest — an annuity is no exception. Annuity fees can amount to as much as three percent a year; tax considerations and other charges could drive the costs higher.

Before you decide on an annuity, it’s important to understand what it will cost you. Some of the charges you might encounter include:

Mortality and expenses fees

Your insurance guarantee comes with a separate cost. This fee covers administrative costs and commissions. This guarantee is basically a promise that your beneficiaries will get your original investment back if you die before receiving a payout.

Surrender fees

Getting out of a contract can be expensive. Your surrender charges amount to the cost you pay if you want to get out of your annuity. Surrender periods vary, and can be anywhere between five and 10 years.

If you try to get out of your annuity within the surrender period, you will pay a huge charge, figured as a percentage of your investment.

Additional riders

Your contract will specify whether or not a spouse can continue receiving payouts if you die. In some cases, your beneficiaries may get nothing if you die after the payout phase begins.

For a price, though, you can add riders to your contract. This allows your beneficiaries to receive money or your spouse to keep receiving (probably reduced) payouts after you die.

No matter what, adding these riders can be costly.

Management fees

If you have a variable annuity, the cost of managing your sub-accounts will reduce your real returns.

Carefully consider before getting an annuity

Because of how complicated annuities can be, carefully consider your options before proceeding.

Be aware that different annuities treat your death differently. In some cases, payouts might continue to your spouse, but not be paid out to other beneficiaries, such as children. In other cases, there is no death benefit, and so your partner or children might be left with nothing.

Watch out for financial professionals and insurers working on commission. The commissions can be substantial and cause a conflict of interest. If you are considering an annuity, work with a fee-only financial planner to see if it’s really the best option for you.

If you decide to go with an annuity, look for the simplest possible contract. The more complicated the contract is, the more it is likely to cost you — and the fewer benefits you are likely to receive.

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