It’s said there are no guarantees in life, and in the financial world, that’s true not only for stocks and interest rates … but also for annuities.
The problem is, while most people know that interest rates will fluctuate and even the most solid stocks can be a bit of a gamble, there is something about that word, annuity, which seems to suggest you’ll be set for life.
Indeed, many annuities do guarantee lifetime payments … but at what cost? For starters, if you’re looking at a flat payment, you should consider what that would be worth in real terms years down the line, after inflation.
There are many different kinds of annuities and all come with volumes of small print that cannot be thoroughly addressed in this piece. So for starters, here’s a retirement 101 primer on things to consider before you buy an annuity.
- They are complex. While the phrase “guaranteed payout” has a nice ring to it, the reality is that there are all sorts of different guarantees and costs attached to them. Some annuities guarantee a payment for a certain period of time, some guarantee payment for life, and some guarantee a combination of the two: a lifetime payout in addition to a guaranteed payment for a certain period of the life of the annuity. Dizzy yet? Well, keep reading the small print.
- They can be pricey. Costs vary, and upfront commissions of 10% are not unusual. Steep penalties for early withdrawals are also common. To keep commission costs low, consider direct-sold annuities from mutual fund companies, which often have lower or even no commissions.
- They require some tough investment choices. If only it really were as easy as signing on the dotted line and waiting for your payout. The reality is that once you consider buying an annuity, you’ll be faced with a host of other decisions about the type and duration of your investment. For starters, you’ll have to choose between a fixed and variable annuity. With the former, you have the benefit of a consistent investment approach and a guaranteed payout, but you’ll face the risk of inflation eroding your real gains. Variable annuities, on the other hand, let you make more decisions about how the money will be invested. But with that upside potential comes more downside risk.
- There can be tax benefits. Money invested in a deferred annuity, as the name suggests, is tax deferred. This is not always enough of a benefit to override the often steep upfront commissions, but it can be beneficial to investors in high tax brackets or those who have maxed out on other tax-deferred retirement savings such as 401(k)s. In addition, annuities purchased with qualified retirement dollars, such as money taken from an IRA or 401(k), do not offer any additional tax benefits.
- They can work like an insurance policy. Despite all the valid warnings that $1,000 today might not be the same as $1,000 20 years from now, annuities can be an effective way to preserve assets. That’s because many offer a survivor benefit that pays beneficiaries the total amount of the principal if you die before cashing in the annuity. This can be an effective tool for preserving your cash through turbulent markets.
If these tips about investing in annuities sound familiar, that’s because the benefits and the drawbacks of annuities are in many ways consistent with all kinds of investments. Be mindful of fees and understand the downside risk, but also recognize that the investment can help lower your tax bill and may help preserve assets.
The difference, of course, is that annuities are too often billed as a safe bet. So explore annuities and consider how they might work for you. But as with all investments, don’t forget to diversify. There are few, if any, scenarios where annuities will be all you need for a secure retirement.
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