Challenges of Retirement Planning with an Annuity (Review) What's the key to a successful retirement plan? In my opinion, it is having a balanced and diversified portfolio. “It's all about striking the right balance between preservation and growth,”...

What's the key to a successful retirement plan? In my opinion, it is having a balanced and diversified portfolio.

"It's all about striking the right balance between preservation and growth," says Rob Williams, vice president of financial planning and retirement income at the Schwab Center for Financial Research. "After all, when you need your savings to last 30 years or more, being too conservative too soon can put your portfolio's longevity at risk."

Depending on your financial situation and retirement goals, this can vary from person to person. But, you'll at least want a mix of stocks, bonds, and cash investments. The reason is that this will generate a steady income stream as you age. And, it will also help preserve your wealth.

Another component of your retirement plan that accomplishes the above? Annuities.

There's a lot to like about annuities. Off the top of my mind, this includes a guaranteed lifetime income, your money grows tax-deferred. But, there are also drawbacks to annuities. And, this can complicate your retirement plan if not taken into account.

Annuities are complex and confusing.

As insurers compete for customers, they have added features and complexities to annuity products. Some of the most common examples include principal protection, participation in the market, death benefits, income benefits, and long-term care benefits. Furthermore, there's a range of payment schedules and investment options. Some of these features may incur additional fees.

Moreover, some advisors and agents may even steer you in the direction of other retirement options? Why? The process for becoming and maintaining the insurance licensing of a financial advisor, the operational complexity of submitting an annuity application, and the added compliance approval process can be expensive and time-consuming.

On the flip side, because they'll earn a commission, some agents may suggest that you buy an annuity that doesn't fit into your retirement plan. For example, commissions on a 10-year fixed index annuity range from 6 to 8 percent, notes Annuity.org. On the other hand, an immediate annuity with a single premium usually carries a 1 to 3 percent commission. And, deferred income annuities carry commissions of 2 to 4 percent.

How can you overcome this challenge?

Brush up on your annuity basics. Obviously, this doesn't mean you have to become an expert. However, at least you won't get talked into an annuity that doesn't fit into your retirement plan.

At the minimum, this means you should be aware of the different types of annuities, which are;

• A fixed annuity is a simple and tax-efficient way to safeguard your retirement savings. They can also provide a predictable and reliable income stream.
• A variable annuity is a riskier option since earnings are tied to stocks, bonds, and mutual funds. Typically, these should be considered if you're younger and have more time to make up for any potential losses.
• A fixed index annuity provides clients with downside protection, as well as growth potential. In short, it combines the best features of a fixed and variable annuity.

For retirees, all the above annuities may offer guaranteed lifetime income options. But, such options may involve additional fees. For more information on annuities, I recommend you check out the following 10 easy-to-understand annuities info.

Participants don't have enough money to purchase an annuity.

Annuities are most commonly purchased from insurance agents or financial advisors. After reviewing the pros and cons with you, you'll fill out the application. But, it's also possible to buy certain fixed annuities directly online.

When it comes to purchasing an annuity, annuity companies stipulate the minimum and maximum premium amount it takes to actually buy the annuity. That means in order to purchase an annuity, you must invest the minimum deposit amount. The minimum deposit for the majority of companies is usually $2,500, but some annuity companies have a lower or higher amount. As for maximum deposits, this varies widely depending on the size of the annuity company.

A larger company may have no problem accepting a deposit of $2 million, while a smaller company may have a limit of $500,000. Some companies, however, may limit how much you can hold in all the annuities you purchase with them.

As a rule of thumb, always contact the carrier for specific limits.

You should first max out other retirement investments.

Most people should not consider an annuity until they have exhausted the tax advantages of other retirement investment vehicles such as 401(k)s and IRAs. However, a tax-free annuity can be a good choice if you have additional retirement savings — especially if you're in a high tax bracket.

You should additionally only consider annuities if you want to delay your Social Security benefits. And, you want to reduce the required minimum distributions from your retirement accounts.

Annuities can be expensive.

Perhaps the biggest criticism of annuities is that they can be expensive. And, that's fair. But, at the same time, depending on the annuity, this might not cost you as much you may have assumed.

While all annuities charge a mortality and expense fee, some fees are specific to certain types of annuities. Moreover, you can expect to pay additional fees if you customize your annuity through rider. With that said, here are some of the most common annuity expenses you may come across.

• Mortality and expense fee
• Administrative fee
• Contract maintenance charge
• Subaccount fee
• Principal protection
• Long-term rider
• Lifetime income rider
• State premium tax (in seven states and Puerto Rico)
• Investment transfer fee
• A contingent deferred sales charge is also called a "surrender charge."
• Inflation protection/cost-of-living adjustment

Before you commit to an annuity, be sure you understand its fees. And, set aside the time to compare fees for similar annuities.

For more detailed information on annuity fees, review our "Become Familiar With Annuity Fees."

You have to balance guaranteed income and financial freedom.

Gallup found that four in five nonretired U.S. investors (85%) believe it's important to have a guaranteed income stream to supplement Social Security in retirement. However, 50% want to be able to spend their retirement savings however they please. What's more, with pension plans becoming less common, balancing this financial freedom has become even more necessary.

The good news? You can clear this hurdle.

Identifying different sources of income to balance these needs is one way to balance them. For instance, retirees can use guaranteed income sources from annuities for essential expenses, such as housing and healthcare. They can then use other assets, such as stocks and bonds, for discretionary or recreational purposes.

They lock in your investment.

"Another key downside to annuities, especially deferred annuities, is their notorious lack of flexibility," writes Jordan Bishop in another Due article. "If you purchase a deferred annuity and need to withdraw money early, it's going to cost you a lot." And, since annuities are long-term contracts, they can be difficult to terminate.

"To start, individuals who buy annuities must wait until they are 59½ years old before withdrawing money from their account," suggests Jordan. "Otherwise, on top of the normal income tax, you'll have to pay the IRS for the early withdrawal (it is a tax-deferred investment for retirement, after all), you'll be hit with a 10 percent penalty from the IRS."

Are you thinking, "What happens if I withdraw early from any retirement account, including a 401(k), not just with annuities?"

"While this is perfectly true, the problem with annuities is that there is also a second fee called a surrender penalty fee charged by the insurance company for early withdrawals," he explains. Typically, you aren't charged this fee based on your age when withdrawing, but rather on the time since you purchased the annuity. "These fees are usually in effect anywhere between 6 and 10 years after entering the contract, and they can be as high as 10 percent."

"You can usually forgo some flexibility if you plan and budget correctly." For instance, "by keeping a liquid emergency fund apart from an annuity, you're less likely to need to make any early withdrawals from the latter." There's also the option of including a contract rider that allows penalty-free withdrawals. But, keep in mind that most of them require an upfront fee.

The main takeaway here is to be patient and do your best not to make an early withdrawal.

Inflation can erode an annuity's value.

Let's be real here. Inflation has the power to undermine the value of any investment.

As an example, the real return from the stock market is only 6% if you earn an 8% return and inflation is 2%. Likewise, if you have a certificate of deposit (CD) earning 1% and inflation is at 2%, your real return is a disappointing one percent.

Assuming long-term historical inflation rates of roughly 3 percent, your annuity payout is unlikely to keep pace with your expenses if it is not adjusted for inflation.

Thankfully, you can purchase an annuity that includes inflation protection. Or, you can buy by an additional rider that allows you to adjust your annuity according to changes in the cost of living. With either, you'll be able to protect your annuity from inflation.

For this benefit, however, expect to pay more — or possibly receive a lower payout.

Higher tax rates.

"When it comes to annuities, there are various tax rules, writes Albert Costill in a previous Due article. "It boils down to if it was purchased with after-tax dollars and is within an IRA or another retirement account." So while IRA owners can invest in annuities, their tax obligations will be determined by their account's tax rules.

"As if this weren't confusing enough, taxes will also differ depending on if you have an immediate or fixed and variable annuity," Albert adds.

When you buy an immediate annuity, only the interest portion will be included in your taxable income, called the "exclusion ratio." "On the flip side, with a fixed or variable deferred annuity, you don't have to pay taxes on any gains until you take withdrawals," he says. "The caveat is that you'll have to pay a 10 percent penalty tax if you take withdrawals prior to age 59½."

There's always a catch with guarantees.

The quality of an annuity's guarantee depends primarily on the financial strength of its insurer. Why? To begin with, unlike bank accounts, the Federal Deposit Insurance Corporation (FDIC) doesn't regulate annuities. As such, you must always verify the insurance company's financial strength ratings through agencies like AM Best, Moody's, and Standard & Poor's.

In case your annuity insurer fails, two outcomes are available at your disposal. For starters, another insurer could take over your policy. However, what if another insurance company doesn't assume control of your annuity? Your other option is to fall back on the coverage offered by your state guaranty association.

Visit the National Organization of Life and Health Guaranty Association's website to find out what your state's limits are. Generally speaking, most states place a limit of $250,000.

Annuities can cause recordkeeping headaches.

"How are recordkeepers and TPAs going report assets used to purchase an annuity on the Government Form 5500 tax filing?" asks Burke Johnson, Executive Vice President and CEO for LT Trust. "Are they to report cash value or book value? For example, if a participant purchases a $100,000 immediate annuity, what is the value of that asset on this year's 5500?

And next year and the year after that? Would it make sense to invest in a deferred variable annuity? "Is each recordkeeper/TPA going to be allowed to use its best judgment for reporting the present value of annuities?" he continues to ask.

"Assessing fees against annuities is another unknown," Mr. Johnson explains. "How are record keepers and advisors going to assess asset-based fees against these investments, especially if the annuity product is not proprietary to the recordkeeper."

Unless a fee has been assessed, advisors may opt not to include them because their compensation will be reduced. Furthermore, open architecture recordkeepers must rely on trading platforms, like Fidelity, Broadridge/Matrix, Schwab, and Mid-Atlantic. These are used to support annuities for the purpose of automating the payment transaction. And, this is key for payroll deduction annuities.

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