The Benefits and Risks of Annuities: How to Know if They’re Right for You
In the realm of investing, few financial instruments have garnered more controversy than annuities. Unquestionably, annuities have their share of critics, especially when they are applied improperly, but, in the right situation, their benefits may be unmatched. Annuities are complex products with many moving parts, so it’s important to do your own due diligence. The key is to understand how they can work in the context of your particular financial situation and to consider both their benefits and their risks. And, since benefits and risks affect people differently, it’s important to carefully assess your own financial situation including your objectives, concerns, priorities and risk tolerance.
The Benefits of Annuities
Tax deferred earnings: For people in the higher tax brackets, annuities are an effective way to shelter earnings from taxes. Although contributions made to an annuity are made with after-tax dollars, the earnings generated inside them are not currently taxed, which means they can grow more quickly. Earnings are not taxed until they are withdrawn. For many people, withdrawals made after retirement may be taxed at a lower tax rate. The other tax benefit of annuities is that, when they are annuitized (converted to a monthly stream of income) the income is not counted towards your Social Security tax calculation.
Investment stability and predictability: No matter your risk tolerance, investing for retirement almost always requires that you include growth investments such as stocks or stock mutual funds as part of a balanced and diversified portfolio. For investors concerned with volatility of uncertainty in the financial markets, annuities can provide your portfolio with stability and predictability. Most annuity contracts include minimum rate guarantees and minimum income guarantees (these can be added as options in variable annuity contracts), so they can form the safety net that will enable you to take greater risks with other portions of your investment portfolio.
Principal guarantees: Your principal investment is guaranteed by the issuing life insurance company. In the century long history of annuities in the U.S., no annuity investor has ever lost a penny of principal. Annuities are issued by life insurance companies which are considered to be the strongest and most stable of all financial institutions. Unlike banks, which are only required to maintain a small fraction of asset reserves, life insurers are required to maintain a nearly 100% reserve to cover all of their obligations. Annuity deposits are also insured by your state’s guaranty fund.
More competitive rates: Fixed annuities offer competitive interest rates that, in most cases, are higher than those offered on bank CDs. As with CDs, fixed annuities offer higher rates of interest with longer term maturities. Many annuities also offer bonus interest rates for larger deposits.
Access to your funds: One of the advantages of annuities over qualified retirement plans is their flexibility when you need access to your funds. Most contracts allow for one annual withdrawal of 10% of your account value without any charge. Excess withdrawals will incur a 10% fee if they occur within the surrender period which typically runs between seven and 12 years. It’s important to note that withdrawals made prior to age 59 ½ may be subject to a 10% penalty.
Guaranteed lifetime income: As life expectancy continues to expand, the greatest risk many retirees face is outliving their income. Annuities are the only investment vehicles that offer a guaranteed income for as long as you live. Many contracts include a cost-of-living adjustment option that ensures your income will keep pace with inflation.
The Risks of Annuities
Fees and expenses: One of the most common criticisms of annuities is that they can be somewhat expensive considering all of the fees and expenses included in the contracts. Because all annuities contracts include a death benefit that guarantees the payment of your principal to your beneficiary, they also include a charge for mortality based on an annual percentage of your account value. Other expenses include administrative fees, and, for variable contracts, investment management fees. For fixed annuity contracts the total fees charges to the account each year amounts to .05% to 1%. Investment management fees can add another 1% to 1.5% each year depending on the type of investment accounts in your portfolio.
Additionally, you will incur a fee if you withdraw more than 10% of your account value in a year. This surrender fee, which can start as high as 12%, is reduced each year by a percentage point until it vanishes.
Life insurer default: While no one has ever lost any of their annuity principal, there have been some instances of life insurer insolvencies, although very few when compared to the hundreds of bank failures over the years. When an insurer becomes insolvent, its obligations are usually taken on by another insurer as required by state law, so the risk of actual default is pretty low.
How to mitigate your risks: With regards to fees and expenses, the hundreds of annuity providers must be able to compete for your deposit, so with some thorough shopping and comparing (easily done online), you can minimize your costs by finding annuities with very low fees. Just be aware that annuity providers with very low fees may try to offset them in other ways such as higher surrender fees. Another way providers will compete is by offering contracts with low or no surrender fees. Again, be on the lookout for higher fees elsewhere in the contract.
With regards to the possibility of default, since it has yet to happen, the likelihood is not very high. However, that doesn’t mean you shouldn’t take some extra steps to protect yourself. First, you should limit your annuity choices to those issued by the strongest and most financially stable life insurance companies. Your best measure of this is with the ratings assigned to all insurers by the independent rating agencies, such as A.M. Best, Standard & Poor’s or Moody’s.
With any investment there are risks, but risks need to be weighed against the potential benefits. With annuities, the benefits are only as meaningful as what they can provide you that no other investment vehicle can when considering your specific needs, priorities, tax status and risk tolerance. Even then, the most effective way to reduce overall risk is to consider any investment as part an overall investment strategy based on balance and diversification.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2014-2016 Advisor Websites.
