Few financial products are as controversial as annuities. Their boosters—including the legions of insurance agents who sell them—will tell you that they’re the best way to assure yourself of a guaranteed income for life. Their detractors—including people who sell other types of financial products—will tell you that annuities are overpriced, laden with fees and an especially raw deal if you die sooner than expected.
There can be a middle ground as well. While annuities aren’t for everybody, they may be appropriate for some people. A lot depends on your financial situation and what kind of annuity you’re talking about, because they come in many different permutations.
In its most basic form an annuity is a contract between you and an insurance company. You make either a single payment or a series of them, and the insurer promises to pay you an income for the rest of your life or some other defined period. You can buy an annuity that will start paying right away, called an immediate annuity, or you can buy one that will start making payments at some point in the future, called a deferred annuity.
Annuities can also be fixed or variable. A fixed annuity will pay a set interest rate on your money while it’s building up (known as the accumulation phase) and then a fixed income stream when you begin collecting (known as the annuitization or payout phase). A variable annuity invests your money in subsidiary accounts such as mutual funds, and the eventual value of the annuity will be based on how well those investments perform. When you begin collecting, you may have the choice of either fixed or variable payments.
There’s also a sort of hybrid called an equity-indexed annuity. It guarantees a fixed interest rate but may also pay more if the index it’s pegged to, such as the S&P 500 stock index, goes up. Of these types the fixed annuity is generally the least complicated and least risky for the buyer, although it also has the least upside potential in a booming economy.
Annuities for Retirement Planning
While annuities have other selling points, such as tax-deferred growth similar to IRAs and 401(k) accounts, their major appeal may be as protection against outliving your money after you retire. Of course, Social Security already provides a guaranteed income for life if you’ve worked enough years to be eligible. However, its benefits may not support you in the style to which you’re accustomed. The current maximum monthly payment (in 2018) is $3,680, and the average recipient gets about $1,404.
Financial planners also have formulas to determine how much income retirees can safely withdraw from their savings each year without running the risk of depleting them before the end of their lives. A common one is the four percent rule, which calls for taking out 4 percent during your first year of retirement and that amount, plus an inflation adjustment, each year thereafter. This “rule” is just an educated guess, based on historical economic data and computer modeling, and comes with no guarantees.
For retirees who are very uncomfortable with risk and feel unqualified to manage their own money—and are unwilling to hire someone else to do it—an annuity can be an option. If that describes you, here are some other things you’ll want to think about.
Consider Your Loved Ones
If you’re married, you may want an annuity that will continue to provide an income for your spouse should you die first. These are commonly known as joint and survivor annuities and can be structured in various ways, such as paying you a certain amount for life and your spouse 50 percent of that amount after you die. You’ll pay more for this type of annuity or receive smaller payments than you would if it covered you alone.
You’ll probably want to get at least three price quotes for the type of annuity you’re considering—and make sure their provisions are identical, so it’s a fair comparison. A fee-only financial planner (the kind you pay for advice and who doesn’t get a commission for recommending a particular product) could be one source of help if you need it. An insurance broker who deals with multiple companies could be another. If you already have accounts with a well-regarded financial-services provider, such as Fidelity, USAA, or Vanguard, you also may want to check into its annuity products.
Pay Attention to Interest Rates
With today’s historically low interest rates on annuities and other traditional retirement vehicles, such as bonds and certificates of deposit (CDs), annuity buyers face the risk that the terms they lock in now may not keep up with the cost of living in the years to come. One way to hedge your bets is by building an annuity ladder, using a portion of your money to buy an annuity now, for example, and adding others in the future at whatever the prevailing interest rates are then.
Find Out What Happens If You Need to Withdraw Money
Unlike more liquid investments, annuities can be costly to tap into if you face an unexpected financial emergency. Some impose surrender fees for a certain period after you buy them. An insurer, for example, might charge you 7 percent of any amount you withdraw during the first year, 6 percent in the second year and so on until the fee disappears. If there’s any chance you might need money quickly, an annuity may not be the best place for it.
Choose a Strong Insurer
Because an annuity represents a long-term commitment on the part of your insurer as well as you, you’ll want to make sure that the company you choose will still be around years from now. (State insurance guaranty funds do provide protection for some types of annuities, but it may be limited.) While it’s no absolute guarantee of future solvency, you can get a sense of how financially strong insurers are today by checking their grades on the websites of the major ratings agencies: A.M. Best, Fitch Ratings, Kroll Bond Rating Agency, Moody’s Investors Service and Standard & Poor’s Financial Services. It’s best to check more than one agency, because they use different criteria and don’t always agree.