Are Annuities the Right Option for Retirees?
Saving for retirement is daunting and inflation can add to the stress. With the recent increase of inflation, retirees are likely concerned about the effect it will have on their plans. One of the strongest selling points for fixed annuities is the assurance they give retirees concerned with whether they will outlive their savings. Retirees can also turn to annuities for an immediate or future stream of guaranteed income in exchange for a lump sum or periodic payments to an insurance company.
The money invested in an annuity can grow tax-deferred but the payments you receive are taxed as ordinary income. However, guaranteed income isn’t always inflation proof. The value of an annuity’s income can diminish and inflation protection for this occurrence doesn’t always solve the issue. Fees, returns, and other conditions vary depending on the company and the type of annuity. You will need a firm understanding of how annuities operate if you want to evaluate these products and pair them with your retirement strategy.
Risk Versus Return
Annuities feature vary features. You can collect payments for a set number of years or request guaranteed payments that last the rest of your life. You can choose when you want to receive income. With immediate annuities, you start receiving payments immediately. A deferred annuity delays income until a future date, which can give your savings time to accumulate.
Another distinction between annuities is how the annuity invests your money. For example, a fixed annuity is a simple version, which works like a CD alternative. For example, your contract might pay a little over 2% return for three years. After the initial period, the contract will pay a return based on market interest rates. Fixed annuities are some of the safest options because you can monitor precisely how much your money will grow over time, as well as the amount of income you’ll receive. Fixed annuities also have the most manageable fees.
Because of their safety and lack of risk, your returns are minimal compared to other types of annuities. This means that fixed annuities are more susceptible to inflation. On the other hand, variable annuities invest in market-based accounts, such as mutual funds, and their savings growth correlates with the performance of the markets. If the investments flounder, your income dwindles. If the investment performs well, so does your retirement income. If the returns perform poorly enough, you can even lose some of your principal. However, annuity companies often guarantee a base level of monthly income even if your account runs out of money.
Fixed-indexed annuities operate between fixed and variable annuities and they have some perks and drawbacks. These annuities are tides to a market index but they have caps and a floor for gains and losses. Common caps for your gains are between 4-7% even if the investment performs much better than that. In exchange for security, you forfeit the higher gains.
The type of annuity you choose should depend heavily on what kind of guaranteed income you want. If you want more stable guarantees, you should focus on a fixed annuity. If you’re looking for higher upside potential, you will want to look into fixed-indexed or variable annuities.
If you have a high risk tolerance, you might be better off investing using your own volition. Annuities can reduce your returns and it’s important to understand the criteria you’re looking for with your annuity. Typically, annuities depend on three categories. First, the contract returns and how much income it pays. Next, you’ll want to examine the fees. Annuities charge upfront commissions and annual fees, such as administration fees, mortality expenses, and investment expense ratios.
Lastly, you should consider how much access you will have to your deposit. Annuities usually have a surrender charge for anyone looking to take out money within the first few years. Surrender charges typically hover around 7%. Some contracts can offer penalty-free early access. They might let you withdraw ten percent of your deposit without having to pay the surrender charge.
You should describe these three categories as a complete picture that determines your annuity choice. You can conceptualize the three areas as levers. When you pull on one, it will likely affect the other. You have to decide which combination works best for you. Fixed interest annuities are easier to evaluate than other types of annuities. Annuity calculators can also help you estimate your income from the deposit on your contract.
Evaluating fixed-indexed annuities is more difficult because the fees are more complex and returns can be challenging to quantify. In particular, variable annuities are so complex that companies are not supposed to let customers review contracts on their own. Financial professionals should meet with their client to determine the best option for them. Financial advisors typically represent multiple companies and they can give you a broader comparison than an agent promoting only one line of products.
Rising inflation and lower interest rates can create the appearance of a poor time to buy an annuity, especially if you plan to purchase one based on a fixed-interest rate. If you need income immediately, there are quite a few drawbacks to waiting. To start, an annuity’s return isn’t solely based on interest rates. The contract will also payout based on a system called mortality credits. In this case, the insurance company collects your money with all the other contract holders who receive a lifelong income.
Another advantage to buying rather than waiting for inflation to abate is that the annuity currently pays more than fixed-income investments such as bonds and CDs. The typical three-year CD only pays around 1%. The typical guaranteed return for a fixed annuity hovers around 2%. You can find bonds that pay higher yields, but those returns are not guaranteed, and there’s a chance you’re going to lose money.
If you don’t need income now, you can set up a fixed annuity for around three years and earn a higher return compared to other fixed income investments. Then you can reinvest the proceeds later if the rates increase. Because annuity earnings are tax-deferred, you also won’t owe as much income tax as you would on bond interest.
When evaluating annuities, you need to consider all angles. Annuities can become an effective part of your retirement portfolio but they can also backfire. Consulting an annuity professional can help save you from any potential downfalls.