Annuities: The Pros and Cons In the wake of the stock market crash and rising interest rates, consumers are buying annuities. In fact, in the third quarter of 2022, insurance industry trade group Limra estimates...

In the wake of the stock market crash and rising interest rates, consumers are buying annuities. In fact, in the third quarter of 2022, insurance industry trade group Limra estimates that annuity sales totaled almost $80 billion — just beating the Q2 record of $79.4 billion.

As of 2022, consumers are expected to purchase almost $300 billion in annuities. Compared to 2008, which was the previous record year, this would smash it by a wide margin.

Fear of stock market volatility and a recession seems to be driving many purchasing decisions, just like during the 2008 financial crisis.

In June, the S&P 500 entered a bear market. As of early November, it's still down nearly 19% in 2022. In the last year, an investor holding U.S. bonds, which usually act as a ballast when stocks fall, lost almost 16%.

Aside from that, the Fed is trying to cool the economy by raising borrowing costs, aiming to tame high inflation; some economists think they might go too far and tip the economy into recession.

It's only natural that people want safety and security during these turbulent times. Annuities do just that.

But, before you dump a ton of money into an annuity, you should first compare the pros and cons.

Let's Cover the Basics of Annuities

It's imperative to understand the basics of annuities before evaluating them. And, the first place to start is quickly explaining what an annuity is.

Basically, it's an insurance contract where the insurer pays you a stream of payments over a specified period in exchange for the premiums you pay. Until the contract is "annuitized" and the owner starts getting payments, these premium deposits earn interest at the rate defined in the annuity contract. Often, this arrangement is sold as "guaranteed income." The terms, however, can vary from one annuity to another.

The owner of an annuity transfers the risk of outliving their retirement funds to the insurance company. This isn't like stocks, bonds, shares, or mutual funds, which the buyer buys to make money. As a result, an annuity is only as reliable as the insurance company that provides it. Even though it doesn't happen often, insurers can and do become bankrupt and/or default on payments, so annuity holders don't always get what they're supposed to. Keep in mind that transferring risk isn't the same as eliminating it.

There's also the complexity and opacity of the contracts involved in annuities. Due to the precise and limited way benefits are defined, annuity terms can be as thick as a dictionary. You'll only know what's offered and whether it's right for you if you read the contract carefully.

Explaining the Different Types of Annuities

Annuities come in three main types: fixed, variable, and indexed. A fixed annuity guarantees you a minimum rate of interest, though these rates can change every year or so. Alternatively, you can invest in mutual funds or other investment funds with a variable annuity. As a result, your payments will be determined by the performance of your investments instead of a fixed rate.

Although indexed annuities are technically variable annuities, they combine the best of both worlds. Your indexed annuity returns aren't based on your investment decisions. You'll actually follow the performance of an index, like the S&P 500. It's important to note that in this case, your money doesn't actually get put into the index. Your account will be credited with the index's returns instead.

In indexed contracts, annuity companies often use participation rates or rate caps to limit returns. They work like this:

• Participation rate. If the S&P 500 grows by 10% in a year and your contract has a 60% participation rate, what will happen? The annuity company will take that 10% growth and give you 60%, which is 6%.
• Rate cap. Taking the S&P 500 as an example, let's say it grows by 8% over a year, and your contract caps rates at 5%. Due to the rate cap, your contract earns 5%, since it can earn no more than that.

Deferred annuities and immediate annuities are also options. If you choose the latter, you give the company a lump sum and start getting payouts right away. Deferred annuities let you pay a lump sum or series of payments, but it takes years for payouts to start. You can earn interest or appreciate your money this way.

Annuity Pros

An annuity is one of the best ways to grow your retirement savings and diversify your portfolio. Annuities are essentially a hybrid between insurance and retirement accounts that let you grow your money. Since annuities have so many advantages, they've become increasingly popular.

You'll Receive Regular Lifetime Payments

Annuities are primarily sold on the fact that you'll get regular payments from an insurance company. In addition to Social Security and pension benefits, these recurring payments can supplement your retirement income. If you're worried that you won't have enough money saved to cover your regular expenses or you'll outlive your savings, this will help you relax. Considering half of Americans worry about outliving their savings, an annuity sounds appealing.

The majority of annuities guarantee you a lifetime income, but you can choose to receive payments over a certain period of time. Also, your annuity payments will vary in value and number. Annuities vary depending on what kind you bought and what your contract says.

Guaranteed Income

No matter how long the annuity owner lives, the insurer is responsible for paying the income. This promise, however, is only as good as the company backing it. The major independent rating agencies only rate insurers for financial strength if they receive high ratings.

Customization

Depending on what is important to you, you can pay only for the features you need. Depending on your circumstances, you might opt for a guaranteed income, invest more heavily in the stock market, or make a fixed payout to your heirs.

Tax-Deferred Contributions

You can make tax-deferred contributions to annuities. Your money isn't taxed until after you retire with a tax-deferred annuity. You don't have to pay taxes until you start getting annuity payments.

Annuities don't require you to pay taxes on capital gains if you don't touch the money while it's in them. When you set up a tax-deferred annuity, you can start getting payments as soon as one year later.

Premium Protection

How does premium protection work? Simply put, it means that you will never lose your purchase payment.

Fixed annuities, for instance, guarantee minimum interest rates on your investment. Don't expect the highest rates. However, it's safe and predictable. With Due, you'll always get 3% back on every deposit.

In addition to premium protection, fixed-indexed annuities offer growth potential during times of market decline. In other words, you have the possibility of growing your investment when the market is rising. As these annuities are shielded from market volatility, there is little risk associated with them.

In addition, annuities have the advantage of not exposing your principal to risk, as opposed to investments such as stocks.

Contribution Limits

An annuity doesn't have annual contribution limits like a 401(k) or IRA. As a result, annuities allow you to invest as much as you want.

No Mandatory Withdrawals

After age 72, you are not required to start taking minimum distributions from your annuity if it is not part of an IRA or other qualified retirement plan. In the event that you are hoping to earn income in later years, that can be a sigh of relief.

Long-Term Care

Most annuities allow you to add a long-term care rider — for an additional cost. As with life insurance, long-term care can help you cover the cost of long-term care if you need it. Long-term care annuities have a growth component and can be passed on to your heirs, unlike life insurance.

The reality is that 7 out of 10 people will need long-term care. Furthermore, long-term care is becoming more expensive. An example would be the cost of a private room at a nursing home, which costs $290 per day ($8,821 per month). The average cost of semi-private rooms is $255 per day ($7,756 per month).

While long-term care annuities don't cover everything, they're still less expensive than insurance policies. According to the American Association for Long-Term Care Insurance, a 55-year-old couple would pay $3,050 per year in premiums.

In most cases, a long-term care annuity will increase your annuity payout. This is usually multiplied by the length of time you will need long-term care. In the case of surgery recovery, your normal income stream could double for five years. It is also possible to withdraw large amounts for free if you require long-term.

There is one more thing. Long-term care riders on annuities are less medically underwritten than traditional long-term care policies. You can still take out an annuity if you need income even if you don't need long-term care.

Death Benefits Are Typically Available

Death benefits can be paid as lump sums or as a percentage of regular income payments to beneficiaries.

In some cases, the death benefit may not be generous at all, or might even not be paid at all. In addition, annuity holders can increase their death benefits.

Annuity Cons

Annuities aren't immune to disadvantages, and neither are other financial products. A lot of annuities charge overbearing fees, for example. Additionally, annuities are safe, but their returns can sometimes be lower than traditional investments.

Complexity.

There is a lot of complexity and personalization involved in annuities. In retirement, you may face unwelcome surprises if you do not understand the stipulations of your annuity contract.

Fees and Commissions

There are some annuities that charge fees, and there are others that don't. Those that do will likely pay 2% to 3% a year in fees. Compared to other types of investments, that fee range is higher. It is for this reason that some investors and financial advisors might find annuity fees problematic.

Among the other fees associated with annuities are:

• Surrender charges. When you sell or withdraw money from a variable annuity during the surrender period, the seller subtracts this charge from the cash value of the annuity. It usually lasts between six and eight years.
• Mortality and expense risk charges. A variable annuity can charge up to 1.25% for this type of charge. Usually every month, the seller adds this charge to cover lost income if an annuity holder dies before the seller had anticipated.
• Administrative fees. You may have to pay fees to the seller of your annuity in order to maintain the account. Costs such as recordkeeping and accounting can be covered by these fees.

Several annuities may also charge a sales commission of 7% or higher in addition to these fees.

Costly Riders

Often, annuities are attractive because of their optional riders. However, if you want lifetime payouts or a minimum guaranteed income, you'll want to pay more, as an example.

Your investment is further diluted if you add fees and commissions.

Illiquidity

Having limited access to your money is one major criticism of annuities. Withdrawals during the surrounding period are especially tricky. Normally, you can only take out 10% of the annuity's value a year. There may also be a surrender fee with some companies.

Early withdrawals, meaning before the age of 59 ½, may be penalized between 5% and 20%.

Furthermore, you will no longer be able to withdraw funds from your account once you begin receiving payments. Because of this, you won't be able to access your money unless you make the scheduled payments.

Difficulty Passing On and Getting Out Of

An annuity can be passed on to someone else if you pass away. However, there are a lot of legal and financial concerns when it comes to passing on an annuity. Plus, plans that let you pay a beneficiary are usually more expensive and pay out less.

It is also true that an immediate annuity may not let you cancel if you decide you want to get out. Most likely, you'll have to pay a fee if you cash out.

Missed Opportunity Costs

A lifetime annuity reduces your risk and guarantees a steady income for life. The question is, at what cost?

An annuity is a long-term investment. Therefore, they have poor liquidity, which makes them unsuitable for handling an emergency or taking advantage of an investment opportunity.

Fluctuating Returns

As a result of market fluctuations, the cash value of a variable annuity can rise or fall. In retirement, this can make your income stream less predictable.

Typically, variable annuities invest in mutual funds that own stocks, bonds, and money market instruments, like Treasury bills. As a result, variable annuities don't have fixed returns.

Inflation-prone

Annuities are particularly vulnerable to inflation and rising living costs since they provide a fixed stream of income. As a result, each annuity distribution has less and less buying power. The problem is especially acute for retirement savers, who often experience higher inflation because of increased medical spending.

You Still Pay Taxes

During the growth phase of an annuity, you don't pay taxes. During this time, your earnings are tax-deferred. As soon as you start taking distributions, you're taxed at a higher rate than most investments.

In basic terms, annuity gains are treated like ordinary income, not capital gains. Rich investors in the top tax bracket, which is 37%, are especially impacted. In contrast, capital gains investments are taxed at 0%, 15%, or 20%.

The Bottom Line

Annuities have pros and cons, so weigh them carefully before signing a contract. In the end, annuities aren't right for everyone.

To determine whether an annuity is good or bad, you must have a clear plan for your retirement. Knowing your risks and what you need for your goals is the only way to decide when and what type of annuity to buy. That is, if they make any sense altogether.

FAQs

1. What is an annuity?

It's a contract between you and an insurance company. The insurer gives you a guaranteed fixed income stream in exchange for a lump sum or series of premiums.

Insurance payouts can last for a period of time or for the rest of your life. Similar to a pension, annuities guarantee income in retirement.

2. What is the difference between a traditional savings account and an annuity?

Savings accounts and annuities are both considered low-risk investment options. Despite this, there are many differences, including fees, liquidity, and minimum account balances.

You can save for retirement tax-advantaged with annuities and retirement accounts, like 401(k)s and IRAs. The difference between annuities and IRAs is that annuities are insurance products that grow money.

There are also generally higher fees associated with annuities than with retirement accounts, but there is no limit to the amount you can contribute.

3. How much does an annuity cost?

The amount you put into your annuity is up to you. These can range from $10,000 to $1 million or more, depending on the type of annuity.

Commissions and fees for annuities can vary, though. The more complex the product, the higher the fee.

Compared to variable or indexed annuities, fixed annuities cost less. The reason is that fixed annuities aren't influenced by stock markets or investment portfolios.

4. What happens to my annuity if I die?

You'll have to check how the insurance company structured your annuity contract.

Depending on the annuity, payments end when you die. But, your spouse or other designated beneficiary will keep getting payments if the annuity has a death benefit provision.

5. Is an Annuity a Good Investment?

Annuities aren't necessarily good or bad investments. For conservative investors who like a hands-off, guaranteed income stream and have a short time horizon, it can be a good investment.

Investors with a long-term time horizon, money to endure near-term market volatility, and the capability to generate income from other investments may find it to be a bad investment.

The post Annuities: The Pros and Cons appeared first on Due.