An annuity, from a very basic standpoint, is an insurance contract. Investors give a set amount of money to an insurance company and, if they “annuitize” their contract later in life, they receive guaranteed income until they pass. The vehicle is a low-risk tool that can help bolster retirement plans, however, annuities can often be confusing and misused if the investor does not fully understand the product.
By highlighting a few pros and cons of annuities, we hope readers will be better educated and more confident in their ability to weigh whether or not to enlist such a strategy.
- Tax deferred. Money inside the annuity will grow tax deferred, which can be an attractive incentive for users who plan to grow the account for many years ahead of retirement. While the annuity will be taxed when earnings are withdrawn, the idea is that the investor will be in a lower tax bracket by that time (being in retirement), and therefore, less impacted by imposed taxes.
- Potential to garner steady income for the rest of your life. If the investor “pulls the trigger” and annuitizes at the right time, the insurance company will pay out a steady stream of guaranteed income until the investor passes away. In addition to other savings methods that the investor likely employed, such as a 401(k), an annuity can provide an added sense of security to retirement funding efforts.
- Guaranteed product = safety net. If you have $1 million dollars, you are (likely) not going to put all of your money into stocks. You would allocate the investable funds in a variety of asset classes to diversify your portfolio. The same methodology goes into annuities – it can be seen as an additional asset class in your overall investment technique. While it is a conservative tool, if the market were to go haywire in the years leading up to retirement, an annuity can act as a protective investment tool.
- Rates can reset. When you are sold an annuity, the first-year interest rate is usually more attractive than the rate that you can come to expect over the long-term. Rates can reset and unfortunately, the annuity holder may not be aware of the anticipated change when they first sign on.
- Pulling funds out early? Expect major penalties. If you withdrawal funds from your annuity contract prematurely, the account will be subject to a number of penalties, including a 10 percent “early withdrawal” fee right off the top.
- Not the best fit for older investors. Annuities are often sold to older investors in their 60s and 70s, however, given the taxation and long-term contract of these tools, it usually is not the most appropriate product for that demographic. These products are not very liquid and investors are locked in for at least 8-10 years before they have full access to their money.
Whether a pre-retiree decides to invest in an annuity or not, it’s important to weigh the pros and cons of this vehicle with the true purpose of why you may need this tool. If you are a younger investor looking to save for retirement in a conservative manner that can offer tax-deferred guaranteed income, than an annuity might fit into your overall financial plan.