Pros and Cons of Using an Annuity for Retirement Income
Find out from Money Girl what an annuity is, and the pros and cons of using one for retirement income.
Laura Adams, MBA
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Pros and Cons of Using an Annuity for Retirement Income
Saving enough for a comfortable retirement is the most important financial goal you can have.
Getting a big fat pension is a luxury that fewer American workers can look forward to these days, and relying solely on a meager Social Security payment will probably leave you scrambling to pay for basic living expenses in retirement.
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If you’re worried that you won’t have enough income for the lifestyle you want in retirement, this episode is for you. I’ll discuss what an annuity is, and the pros and cons of using one for retirement income.
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What Is an Annuity?
An annuity is a contract between you and an insurance company that promises to pay you income. Different types of annuities are sold by a variety of institutions and professionals, such as insurance companies, banks, and financial advisors.
You can purchase an annuity by making a lump sum payment, or making multiple payments–called premiums–over time. In return, the insurance company invests your money and typically gives you a series of payments, which is called annuitization.
If your payments start right away, it’s called an immediate annuity; if they’re delayed until some time in the future, it’s a deferred annuity. The income you receive from an annuity can be paid out monthly, quarterly, yearly, or even as a lump sum payment.
A big advantage of annuities is that you can contribute as much as you want for retirement. Unlike other tax-deferred vehicles—such as a workplace 401(k) or an IRA—annuities have no annual contribution limits.
Having the option to put away more money is critical, especially if you’re close to retirement age and need to catch up. Annuities were created to provide an income stream that lasts a certain period of time, or even for as long as you live, so you never run out of money in retirement.
See also: 10 Things You Should Know About 401(k) Plans
What Are the Main Types of Annuities?
Before I cover the pros and cons of using annuities for retirement income, it’s important to understand the basic differences between the 2 main types: fixed and variable.
It’s important to understand the basic differences between the 2 main types: fixed and variable.
A fixed or guaranteed annuity gives you a minimum rate of return that never changes, no matter what happens in the financial markets. The insurance company handles all the backend investing and agrees to pay you a minimum, pre-determined rate of return and payout. In other words, the insurance company assumes all the risk, and you receive a stable cash flow.
On the other hand, a variable annuity does not give you a stable payout. The rate of return depends on the performance of the financial markets. You decide how to invest your money in investment sub-accounts held within the annuity.
Unlike fixed annuities, variable products are securities that must be registered with the Securities and Exchange Commission (SEC.) They do give you the potential to earn more than a fixed annuity, but the cash flow is much less stable, and you can lose money.
The value of using variable annuity products for retirement income is hotly debated. In addition to having higher risk, they also come with higher commissions and fees compared to fixed products, which may make them unsuitable for many investors. Therefore, for the purpose of this article, I’m just going to focus on fixed annuities.
What Is an Annuity Rider?
Other features of annuities that you should be familiar with are optional benefits called riders. Just like you can add a rider to a home insurance policy to protect valuable jewelry, you can add a rider to an annuity and receive additional value above the standard contract.
Here are some common annuity riders:
- Income rider: provides guaranteed income for a certain period of time that you can turn on in the future. This is a popular option for retirees who want to make sure that they don’t run out of money during their lifetime. I’ll give you an example of how this works in a moment.
- Death benefit rider: ensures that if you die, your beneficiary will receive the balance of your annuity—not the insurance company. For example, if you purchase an annuity for $100,000, but die after receiving only $20,000 in distributions, your beneficiary would receive the balance of $80,000.
- Nursing home rider: helps pay for expensive long-term care, either in a nursing facility or at home. For instance, it may double your monthly income, or allow you to withdraw more of your annuity balance to cover your added costs.
- Terminal illness rider: allows you to access some or all of your annuity balance, without having to pay early withdrawal fees or surrender penalties, if you’re diagnosed with a terminal illness that reduces your life expectancy. I’ll tell you more about surrender charges coming up.
It’s important to remember that adding a rider to an annuity gives you extra financial protection, but it comes with a cost, because it reduces the amount of income you’ll receive.
See also: Annuity Riders Protect Aging Seniors
3 Pros of Using a Fixed Annuity for Retirement Income
To know whether an annuity is right for your circumstances, weigh the pros and cons carefully, and seek advice from an annuity professional who can answer your questions.
Pro #1: Principal Protection
When you purchase a fixed annuity, the money you put in is completely safe. The worst-case scenario is a lower-than-expected return, never a loss of your principal.
Even if the insurance company goes out of business, every state has a guarantee association that gives policyholders a certain amount of protection. It varies by state, but generally ranges between $150,000 and $300,000.
One of the most unique features of an annuity is the option to receive lifetime income.
Pro #2: Guaranteed Income
One of the most unique features of an annuity is the option to receive lifetime income. Here’s a rough example:
Let’s say you purchase a $100,000 annuity with an 8% income rider at age 60. If you want to begin taking income at age 70, you’d receive approximately $1,000 per month for the rest of your life.
If you live another 20 years, your $100,000 annuity would pay out $240,000 ($1,000 x 12 months x 20 years) over your lifetime. That’s a terrific return that you’re not likely to get from a typical investment, such as a mutual fund. But if you only live 5 years, the annuity company gets the better deal.
Pro #3: Tax Deferred Growth
The growth in your annuity is tax deferred, similar to the way earnings are handled within a retirement account, such as a traditional IRA or 401(k). That means your money compounds year after year, and you don’t receive a tax bill until you take withdrawals.
Additionally, when you receive an annuitized income stream, the payment is a combination of earnings and principal. Since your principal was put in on an after-tax basis, that portion is never taxable. You’ll owe tax on the earnings portion only of your withdrawals.
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3 Cons of Using a Fixed Annuity for Retirement Income
While there are pros to just about every financial product, there are also cons. So always weigh the advantages against the disadvantages before you make a financial commitment.
Con #1: Loss of Liquidity
After you purchase an annuity or make contributions, your money is locked in for a certain period of time. If you take the money out, it’s typically subject to a surrender charge that could be 8% or more of your account value after one year. The charge generally decreases each year until it gets to zero. However, some products allow for a certain amount of penalty-free withdrawals.
Once you annuitize the account, or start receiving income, you give up access to your account in exchange for the cash flow.
Con #2: Early Withdrawal Penalties
Since annuities are designed for retirement, the IRS typically charges a 10% penalty if you withdraw gains from the account before reaching age 59½. Plus, you also have to pay ordinary income tax on those earnings. However, as I previously mentioned, you’re never taxed on withdrawals of your principal because they are paid into the account on an after-tax basis.
So, just like with an IRA or 401(k), you should never put money into an annuity that you might need to spend before reaching the official retirement age of 59½.
Con #3: No Growth Feature
Fixed annuities offer no or little potential growth when compared to other options for your money, such as investing in stocks or mutual funds. However, a smart way to get the opportunity for growth while protecting your principal from market volatility is with a fixed indexed annuity, or FIA. It gives you guaranteed income based on the performance of an index, such as the S&P 500, that’s used as a benchmark.
But with a fixed indexed annuity, you’re not directly invested in the index or market. So you balance risk and reward by earning more when the market is up, but are guaranteed to never lose value when the market is down. That safety gives you peace of mind that your money is safe from fluctuations in the market, which can make all the difference during retirement.
Visit the Indexed Annuity Leadership Council website at indexedannuityinsights.org to learn more about annuities. They have some great interactactive tools, calculators, and videos to help you build a retirement nest egg.
Do Your Homework Before Buying an Annuity
Remember that the purpose of an annuity is to transfer the risk of running out of principal or income in retirement to an insurance company. Annuities come with terrific benefits that you won’t find in any other financial product—but they also have drawbacks. The pros and cons that I’ve covered are not a complete list.
So, do your homework and make sure you understand all the features of an annuity, and how it can help you solve your financial needs in retirement, before jumping in.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.