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Planning for retirement requires careful consideration, especially when it comes to securing a reliable income stream. Annuities are often marketed as a safe and dependable option, promising guaranteed payments for life. However, while they may seem appealing, annuities come with complexities, high fees, and potential risks that can impact your long-term financial security. Understanding both the benefits and drawbacks of annuities is essential to making an informed decision about your retirement strategy.
An annuity is essentially an insurance contract. The insurance company collects premium payments for a certain period of time, invests the money at a certain earnings rate, and then, at some point, makes monthly payments to you for a certain period of time. The primary difference between an annuity and a life insurance policy is that annuity benefits are paid to you during your lifetime, rather than to your beneficiary after you’ve passed away.
There are different types of annuities for retirement, and differences between them revolve around when benefits start and whether the earnings rate is fixed or variable. Essentially, this allows you to choose from four different combinations.
Types of annuities
Immediate annuities: Your benefit payments begin almost immediately. Typically, you would make a large one-time contribution or premium payment, and then, within a year, the insurance company would start paying you benefits.
Deferred annuities: Your benefit payments don’t begin for a while. Typically, you make monthly, quarterly, or annual premium payments over several years. With both immediate and deferred annuities, you can choose between a fixed or variable earnings rate.
Fixed annuities: The insurance company guarantees a certain interest rate on your money. This provides a predictable income stream, but it may not keep up with inflation over time.
Variable annuities: Your returns are based on the performance of investments you select, such as mutual funds. This offers the potential for higher returns but also comes with greater risk.
Concerns to consider
While annuities can provide a steady income stream, they come with certain dangers and complexities that retirees must be aware of.
Over-reliance on annuities: One of the primary dangers posed by annuities is people's tendency to over-rely on them to meet their retirement needs. Your retirement cash flow needs to meet your living expenses, which will increase with inflation for as long as you live. Your retirement cash flow must also grow with inflation, or your retirement lifestyle will deteriorate; if you don’t keep up with inflation in retirement, you will be able to buy less and less each year, as inflation inexorably increases the prices for everyday items.
Complexity and hidden costs: Annuities come with a dazzling array of options and combinations of start dates, earnings rates, and payment options. These complexities present challenges and risks that retirees must manage. Unfortunately, most annuities tend to underperform compared to equivalent investment accounts. This issue becomes more acute for individuals aged 50 and above, who have less time to recover from such financial setbacks. Seniors are often the preferred demographic for annuity salespeople, leading to a prevalence of sales abuses and false promises within the insurance industry.
Inflation risk: Many annuities provide fixed payments, which do not adjust for inflation. Over time, the purchasing power of these payments can decline, leading to a reduced standard of living. Some annuities offer inflation protection, but this typically comes at the cost of lower initial payments.
Liquidity constraints: Annuities often come with surrender charges and penalties for early withdrawal, limiting your access to funds in emergencies. This lack of liquidity can be a significant drawback for retirees who may need flexibility in accessing their savings.
Tax considerations: While annuities offer tax-deferred growth, withdrawals are taxed as ordinary income, which may be higher than capital gains tax rates. Additionally, if you withdraw funds before age 59½, you may be subject to a 10% federal tax penalty.
Evaluating annuities in your retirement plan
Given these complexities and potential pitfalls, it's crucial to carefully evaluate whether an annuity aligns with your retirement goals and financial situation. Consider the following steps:
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Assess your income needs: Determine how much income you'll need in retirement and whether an annuity's fixed payments will be sufficient to cover those needs, considering inflation and potential unexpected expenses.
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Understand the terms: Thoroughly review the annuity contract, paying close attention to fees, surrender charges, and the financial strength of the issuing insurance company.
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Consult a fiduciary advisor: Seek advice from a fee-only financial advisor who is legally obligated to act in your best interest. They can provide unbiased guidance on whether an annuity is suitable for your situation.
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Consider alternatives: Explore other retirement income strategies, such as dividend-paying stocks, bonds, or a systematic withdrawal plan from a diversified investment portfolio.
Although annuities can offer a guaranteed income stream in retirement, they come with significant risks and complexities. It's essential to thoroughly understand these products and consider whether they align with your financial goals and risk tolerance. Consulting with a trusted financial advisor can help you make informed decisions and avoid potential pitfalls associated with annuities.
Greg Welborn is a principal at First Financial Consulting. He works with individuals and privately-owned businesses on financial planning issues, including investment, retirement, and tax planning, among others. With more than 35 years’ experience, he has developed a strong track record of providing 100% objective advice.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.