In a perfect environment, the market is always positive, the economy is always booming, and no one runs out of money. However, with stock market valuations hovering near record highs, volatility increasing, and inflation staying persistent, many of our clients are searching for solutions to protect their next egg.
Certain annuities can provide guaranteed interest for a set number of years, similar to treasuries or CD’s. Other annuities work more like a pension check where they provide payments for life. Some annuities allow savers to boost their retirement savings more tax efficiently.
In the past, annuities tended to have a stigma attached to them. They had confusing terms, high fees, and oftentimes insurance agents lined their pockets with large commissions. Today, the annuity industry has evolved. There are a large variety of solutions with no commissions or annual fees, and tools that help clients better understand the pros and cons of the solution.
When planning for retirement, many investors turn to annuities as a way to secure guaranteed income or grow their wealth over time. Annuities come in a variety of forms, each with its own set of advantages and disadvantages depending on your financial goals and risk tolerance. In this article, we’ll explore the pros and cons of the three most common types of annuities: Deferred Fixed Annuities, Income Annuities, and Variable Annuities.
1. Deferred Fixed Annuities
A deferred fixed annuity is a contract with an insurance company where you make a lump sum payment or series of payments in exchange for guaranteed interest over time. This is very similar to a CD or treasury. The key feature of a deferred fixed annuity is that the payments to you don’t begin immediately. Instead, you defer the income to a later date, often when you retire.
Pros of Deferred Fixed Annuities:
- Guaranteed Returns: The primary benefit of a deferred fixed annuity is that it offers a guaranteed return. Your principal is protected, and the insurance company guarantees a minimum interest rate, which can provide peace of mind, especially in uncertain markets.
- Tax-Deferred Growth: Like other annuities, the money in a deferred fixed annuity grows tax-deferred, meaning you won’t owe taxes on the earnings until you begin withdrawing funds.
- Simplicity: Deferred fixed annuities are relatively simple to understand compared to other types of annuities. You know exactly what your returns will be based on the terms of your contract.
- No Market Risk: Since the return is fixed, there’s no exposure to the stock market, which can be appealing for conservative investors.
Cons of Deferred Fixed Annuities:
- Low Returns: The guaranteed interest rate on deferred fixed annuities is often lower than what you might earn in the stock market.
- Inflation Risk: Since the return is fixed, inflation can erode the purchasing power of your payments over time. Fixed returns may not keep up with the rising cost of living.
- Liquidity Issues: Like most annuities, deferred fixed annuities have surrender charges if you withdraw funds before a certain period, often 5–10 years. This makes them less liquid than other investment options.
- Early Withdrawal Penalties: If you need to access the money before the annuity’s payout phase begins, you could face penalties and fees, making them less flexible than other retirement savings vehicles.
2. Income Annuities (Immediate Annuities)
An income annuity, also called an immediate annuity, begins making periodic payments to you shortly after you make a lump sum payment to the insurer. This type of annuity is often used by retirees seeking a predictable income stream for a set period or for life.
Pros of Income Annuities:
- Guaranteed Income for Life: One of the biggest advantages of income annuities is that they can provide a guaranteed stream of income for the rest of your life, no matter how long you live. This can help protect against longevity risk (the risk of outliving your savings).
- Simplicity: Income annuities are relatively simple. Once you make the initial payment, you know exactly what to expect in terms of income. This makes it easier to plan for future expenses.
- No Market Risk: Income annuities are not affected by market fluctuations, which means your income is predictable, even in volatile markets.
- Tax Deferral: Similar to deferred annuities, income annuities benefit from tax-deferred growth, meaning you don’t pay taxes on the earnings until you start receiving payments.
Cons of Income Annuities:
- No Access to Principal: Once you purchase an income annuity, you typically cannot access the lump sum you paid into it. The money is locked in, which can be a disadvantage if you need liquidity or an emergency fund.
- Inflation Risk: If you don’t add an inflation rider, your income payments will remain fixed over time. As prices rise, the purchasing power of your income can decrease.
- Limited Flexibility: Unlike other investment vehicles, once you commit to an income annuity, you generally can’t change the terms of the contract. It’s a “set it and forget it” product, which might not be ideal for people who need flexibility in retirement.
- Lower Initial Payments: The amount of income you receive will depend on factors such as your age, health, and the size of your initial payment. If you’re younger or in good health, the payout might not be as high as other options.
3. Variable Annuities
A variable annuity is a more flexible type of annuity where the payout is tied to the performance of underlying investments, usually mutual funds. With a variable annuity, you have the potential for higher returns (and higher risks) compared to fixed annuities.
Pros of Variable Annuities:
- Potential for Higher Returns: The primary advantage of a variable annuity is the opportunity for greater returns. Since the value of the annuity is tied to the performance of the investments you choose, you have the potential for higher growth compared to a fixed annuity.
- Investment Flexibility: With a variable annuity, you can often choose how your funds are allocated across a range of investment options (stocks, bonds, mutual funds, etc.), allowing you to tailor your investment strategy to your risk tolerance and goals. Some variable annuities also guarantee a minimum return.
- Tax-Deferred Growth: As with other types of annuities, earnings in a variable annuity grow tax-deferred until you begin withdrawals.
- Riders and Guarantees: Many variable annuities offer optional riders (for a fee), such as guaranteed minimum income benefits or death benefits, which can provide additional security in case your investments don’t perform as expected.
Cons of Variable Annuities:
- Market Risk: Unlike fixed annuities, the value of a variable annuity fluctuates with the performance of the underlying investments, which means you could lose money if the markets perform poorly.
- High Fees: Variable annuities tend to have higher fees than other types of annuities, including investment management fees, mortality and expense fees, and costs for any riders you add to the contract.
- Complexity: With the various investment options and optional riders, variable annuities can be complex and difficult to understand. If you’re not familiar with investment markets or annuity contracts, you might struggle to make the most of your annuity.
- Surrender Charges and Liquidity: Like other annuities, variable annuities come with surrender charges if you withdraw funds early. Additionally, your funds might be tied up for years, which could limit your ability to access the money in the short term.
Which Annuity is Right for You?
- Deferred Fixed Annuities are best for conservative investors who want a guaranteed return and don’t need immediate access to their funds.
- Income Annuities are ideal for retirees seeking a predictable, guaranteed income stream for life and who are willing to lock in their principal.
- Variable Annuities are suitable for those who want to take on more risk in exchange for potentially higher returns, have a longer investment horizon, and can handle the higher fees and complexity.
Before purchasing any type of annuity, it’s essential to assess your retirement goals, risk tolerance, and liquidity needs with a financial professional. If you would like to learn more, please contact us to see how annuities may fit in your plan.
