If you’re anywhere close to retirement, then it is likely that you’ve at least heard about annuities. But, while these financial vehicles can fit nicely into many investors’ portfolios, the reality is that they can also do more harm than good if they are purchased for the wrong reason(s).
That’s why it is imperative that you know why you are leaning towards the purchase of an annuity in the first place – and that you are then able to compare the pros and cons of the annuity features that can provide you with the most benefit for your unique needs.
Why Consider an Annuity?
Although there is a long list of reasons why someone might be considering an annuity, these products were initially designed for providing a stream of income. Whether that income will be your sole source of incoming cash flow in retirement, or simply added as a supplement to one or more other sources of your future retirement income, will depend on your specific situation.
With that in mind, let’s take a look at some basic math.
Let’s say that you’ve added up all of your future living expenses, such as housing, utilities, transportation, insurance, travel, and other costs, and you anticipate your expenses in retirement to be about $6,000 per month.
Once you have determined an approximate expense figure, you can then go through and decipher all of your potential sources of income in the future. In this particular example, let’s say that the following income sources will be available to you:
- Social Security – $3,000 per month (you and your spouse combined)
- Pension – $1,000 per month
With a pension of roughly $1,000 per month, and another $3,000 monthly coming in between your and your spouse’s Social Security, your total monthly income in the future looks to be in the neighborhood of $4,000.
But, with $6,000 in expenses, and $4,000 in anticipated income coming in, you currently have an income “gap” of $2,000. ($6,000 – $4,000 = $2,000).
Where will that other $2,000 come from?
One option is from an annuity.
In the past, many retirees relied on growth and/or dividends from stocks to provide them with the additional income that they needed in retirement. Today, however, given the volatility of the market, this is not a viable option for generating an income you can count on.
But an annuity very well could be.
Other Benefits of Owning an Annuity
In addition to their ongoing income stream, annuities can also provide some nice enhancements to your portfolio long before you become a retiree. One highlight, for example, is that deferred annuities offer tax-deferred growth.
(A deferred annuity is one that you hold for a while before you start generating income, whereas an immediate annuity is an annuity that will begin generating income immediately – or very soon after – you have purchased it).
So, while your money is growing inside of the deferred annuity’s account, there is no tax due on the gain until the time of withdrawal. This, in turn, can allow your funds to grow and compound exponentially over time – much more than a taxable account will.
This is because your money is earning interest on the principal, interest on the interest, AND interest on the funds that would have otherwise been used for paying taxes on the gain each year.
Because there are so many Baby Boomers today that are heading into retirement, insurance companies are all essentially vying for your business – and in doing so, they are continuously adding new annuity products to their pipeline.
Unlike the more “basic” annuities in the past, today’s annuity offerings will oftentimes include a long list of “bells and whistles,” such as critical illness and nursing home riders, roll-up rates, stepped-up death benefits, and other items that may make the annuity appear really enticing, but that can also make it more confusing – and possibly even more costly – with features that may or may not necessarily benefit you.
So, when doing a check of annuities pros and cons, there are some things that truly matter, and some things that might initially appear to be important, but that really won’t get you any closer to meeting your short- or long-term financial objectives.
Let’s separate out each type of annuity and go over the pros and cons of each:
Fixed Annuity Pros and Cons
As with most other fixed financial products, there can be both advantages and drawbacks. The same holds true with fixed annuities. Some of the pros with fixed annuities are their safety of principal – regardless of what happens in the market. So technically “on paper,” you won’t lose money in a fixed annuity.
Plus, because annuities allow tax-deferred growth, a fixed annuity grows and compounds over time until the time you are ready to convert it over into an income stream. At that time, you will receive a fixed, known amount of income for the time period that you choose. This may be for a set number of year, or it could even be for the remainder of your lifetime – regardless of how long that may be.
Due to the low-interest rate that is offered on fixed annuities, though, these products can have a hard time meeting – much less beating – inflation, so you could lose purchasing power over time. This can be an issue if you are counting on the income from a fixed annuity for a long period of time, while the prices of the goods and services you need to purchase continue to rise.
Variable Annuity Pros and Cons
A variable annuity allows its holder to participate in stock market appreciation through a number of investment options, such as mutual funds. The money you have in a variable annuity is not, however, invested directly in the stock market.
If you own a variable annuity, you have the opportunity to grow your money a great deal – provided that the underlying investments perform well. But just the opposite can be true, too. So, if the underlying investments perform negatively, then it can be quite risky, and you can lose value in your account.
Indexed Annuity Pros and Cons
Indexed annuities are sometimes described as the “best of all worlds”…but be careful because if something sounds too good to be true, it very well could be! There are some definite advantages with fixed indexed annuities though.
First, these products offer you the opportunity to earn a return that is tied to an underlying market index. Some of the more common indexes you will see tracked with fixed indexed annuities are the S&P 500 and the DJIA (Dow Jones Industrial Average).
If the index that the annuity is tracking performs well, then it will be credited with a positive return – but…and this is important…there is usually a “cap,” or a maximum amount of return that will be credited.
As an example, if the underlying index returns 10% in a given year, but the stated cap on your annuity is 5%, you will only receive a 5% return credited. In fact, even if the underlying index goes up by 20% or more, your maximum will still only be 5%.
In a “tradeoff” of sorts, though, if the underlying index performs badly in a given year, the indexed annuity will simply be credited with a 0% – even if the index’s return falls by 20% or more.
This protection of principal can be crucial – especially if you are nearing retirement and do not have a great deal of time to wait for the market to come back up. With that in mind, it is important that you weigh out the pros and the cons with indexed annuities, or any other type of annuity that you may be considering.
Which Type of Annuity is Best for You?
So, which type of annuity is best for you?
The answer to that question is that there really isn’t one single across the board right answer. In other words, the bottom line is that, whether or not an annuity is a good or bad investment is really dependent on why you are considering the annuity in the first place.
If you just aren’t sure how to take the next step in determining what type of annuity to choose – or even if an annuity is right for you at all – let Annuity Gator help. We focus on investigating and comparing annuities so you don’t have to do all of the legwork on your own. And, if there’s a particular annuity that you want to know more about, check out our annuity review database, the largest source of annuity reviews on the Internet!