When talking about retirement, income is one of the main points of discussion. Will Social Security be available? Will you work part-time? Will you investments be enough to cover your expenses?
One polarizing tool that can provide income during your retirement years is an annuity. However, the merit of annuities is hotly debated in the financial community.
Are annuities a good way to use your hard-earned money to fund your retirement? I am going to dive into the details, and at the end I’ll give you my recommendation on a general level. As always, you should work with a professional, fiduciary financial planner for any personalized investment advice.
Annuity Product Options
Annuities are essentially insurance products — you pay in to purchase the annuity, and the company agrees to make payments to you in the future. Annuities are also sold by some banks, brokerage firms, and mutual fund companies. Beyond that, there are several variations of annuity products available. They can be a sort of hybrid of an investment and an insurance product, but personally I consider them to be closer to insurance (I’ll explain this further, below).
Payout Value
There are three different methods that can determine your annuity benefit payout value.
- Fixed annuities promise a minimum rate of interest and a fixed amount of periodic payments.
- Variable annuities allow you to direct your payments to a different investment option, like a mutual fund — so, your payout will vary.
- Indexed annuities offer a return based on the performance of a stock market index, like the S&P 500.
Phases
If you are considering an annuity, you’ll hear people talk about the two phases of the product.
I like Investopedia’s description: “The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase. Once payments commence, the contract is in the annuitization phase.”
Payout Schedule
Annuities will start paying out the benefit to you either within 1 year (which is called an immediate annuity) or later (deferred annuity) — these details will be detailed in the contract.
Benefit Period
Your annuity benefit payouts can be set up to last for your whole lifetime or for a fixed period (for example, 25 years).
The Positives of Annuities
The appeal of annuities is pretty clear — “guaranteed” income during your retirement.
That concept alone sounds nearly magical, doesn’t it? All of your retirement planning problems solved! But that benefit isn’t truly a sure thing, as I’ll outline below.
As the saying goes: if it sounds too good to be true, it probably is too good to be true. There are some major drawbacks.
The Negatives of Annuities
Risk
Depending on the details of the annuity product, the payout benefit value isn’t fully guaranteed. An indexed annuity benefit, for example, could shrink if the stock market recedes. Worse still, your benefit is being paid by a company, so what will happen to your retirement income in the future if that company is no longer around?
If you choose an indexed or variable annuity product, you are also still partially exposed to risk of volatility in the stock market. Though, as you’ll see below, that’s something I’m personally comfortable with in the long-term.
Inflation/Cost of Living
If you choose a fixed annuity, inflation during your retirement decades can put you in a difficult spot.
Consider this example. Your current monthly expenses are $2,000, so you choose a fixed annuity product that will pay out $2,000 per month for your whole lifetime. If inflation causes your monthly expenses to increase 3% per year, then in 30 years those expenses will be about $4,900 per month — so your $2,000 annuity benefit would be insufficient.
Lack of Flexibility (Surrender Charge)
If you want to sell or withdraw the money you paid into your annuity, you could be subject to a surrender charge in addition to taxes and other possible penalties. Surrender charge details will be described in the contract.
High Commissions
Salespeople make notoriously high commissions when selling annuities — up to 10% on what could be a large portion of your retirement savings! So, if you are speaking with a highly enthusiastic salesperson who’s encouraging you to purchase an annuity, that may be a factor.
It’s Complicated
You can probably tell that annuities are just more complicated than other investments.
It can be exhausting to try to understand your specific contract and when, why, and how much you will be penalized or owe new fees.
Fees
I’ve highlighted a few of the possible annuity fees already, but here’s a detailed outline of common fees you may owe if you purchase an annuity product:
- Mortality and expense risk charge
- Administrative fees
- Underlying fund expenses
- Surrender charges
- Commissions
- Investment management fees
- Rider charges
- Fees and charges for other features
Even once you’ve purchased the annuity product, annual fees can be “up to 3% or more per year.” Compared to investment alternatives, these annual fees are huge and noncompetitive. Over a few decades, losing 3% per year to fees will eat away at the growth.
For comparison, many of the larger brokerage companies are now offering non-annuity investments, like index funds, with super low expense ratios. Fidelity is now offering index funds at as little as 0% annual expense ratio. Vanguard and Schwab also have competitive products with low expense ratios, if you’re looking to shop around. (None of these companies are sponsors of mine, they just truly offer good products.)
Recommendation
Personal finance celebrity Dave Ramsey and his team, who are notoriously conservative, say that they very rarely recommend purchasing an annuity. The only scenario where they would endorse one is a variable annuity, and only if you’ve maxed out your other tax-favored retirement plans and you’ve paid off your home.
Full disclosure, I am a couple decades away from retirement — but, personally, I don’t plan to ever purchase an annuity product. Therefore, I don’t recommend that readers purchase one. There are too many other more flexible, lower-cost investments available.
These alternatives may be subject to volatility, but with proper cash reserves and other self-imposed guidelines in place, they can be reliable options.
Alternatives
Your investment decisions should always be based on your specific goals for the funds.
Taxable Brokerage and Retirement Accounts
In the context of annuities, you’re likely considering your retirement years and looking at an investment horizon of many decades. I recommend not investing the money into the stock market or index funds unless you’re considering a period of 7 years or longer — so that criteria is satisfied.
Beyond that, I’m a big fan of investing in diversified index funds or exchange-traded funds (ETFs) within tax-advantaged retirement accounts. If you haven’t maxed out your retirement account deposit options, I would recommend starting there first.
Even if you are planning to retire early, there are ways you can access your retirement accounts early while avoiding the early withdrawal penalty.
Then, you may even want to consider investing further in a taxable brokerage account. You will owe taxes on the growth, but you’ll still have lower annual fees and more flexibility than in an annuity.
Index funds and ETFs have low expenses (unlike annuities) and are available in both tax-advantaged retirement accounts and taxable brokerage accounts.
Volatility
If you’re not comfortable with the stock market or index funds, you could consider investing in a larger percentage of bonds and bond funds within your investment accounts to reduce volatility.
You could also consider increasing your cash reserves so that you wouldn’t have to withdraw from your investments during volatile periods — up to 3 years of expenses in cash reserves could be justifiable during retirement.
If you’re still able to work, another way to reduce the effect of investment volatility is to consider working part-time during the beginning of your retirement period. Income from a semi-retirement lifestyle would reduce your reliance on your investment income, so you could leave more of your funds invested during times of volatility.
Other Options
A very conservative option you could choose is investing in certificates of deposit (CDs).
If you’re looking for something completely different, you could invest in real-estate, peer-to-peer (P2P) lending, or in entrepreneurship through starting your own business or investing in someone else’s fledgling business.
Conclusion
There are many retirement investment options available to you.
I don’t want to paint the picture that annuities are always necessarily bad, but I do encourage readers to approach them with some skepticism. Don’t make an impromptu decision to purchase an annuity product with your retirement savings.
Read the contract details carefully and seek third-party professional input before choosing to purchase one.
