Are you wanting reliable income in retirement? Annuities are one option that you might turn to. An annuity pays you an ongoing income stream and lets you avoid running out of money. It’s the only thing besides Social Security that will generate guaranteed income for life. But of course, annuities have pros and cons, just as everything does.
When you start an annuity, you own a ‘money for life’ contract between you and a life insurance company. The insurer promises to give you regular payments for a set period or the rest of your life. Insurance companies have a strong record of meeting these commitments in all sorts of economic conditions and stock market cycles.
Annuities come in a variety of flavors. Some annuities are just base contracts, while other annuities offer add-on benefits that offer a lifetime income stream and liquidity. In other words, you have many choices and ways to customize an annuity to your personal goals, needs, and financial situation. It’s a matter of finding the right annuity for you.
In this article, we will go over the pros and cons of annuities for retirement income. As a guaranteed income source, annuities are a great way to maximize your money, but they aren’t for everyone. We will also talk about situations in which they can really make a difference.
What Kinds of Annuities Are There?
Before getting more into the pros and cons of annuities, it helps to cover their basics. There are five basic types of annuities: immediate annuities, fixed annuities, multi-year guarantee annuities, and variable annuities.
Immediate annuities start paying you income right away. The four other types of annuities tend to fall into the deferred annuity camp, which means you wait for a certain period before you start your annuity income stream.
Fixed annuities give you a guaranteed rate of growth for a set time. For example, your fixed annuity may pay a 4% rate for two years, then a new guaranteed rate is issued. Multi-year guarantee annuities (MYGAs) work the same way, but they guarantee the interest rate for a longer period. For example, a MYGA may pay 5% per year for five years, and that is the length of your annuity commitment.
Variable annuities let you invest your money in subaccounts, or underlying accounts that resemble mutual funds. Your money is actually invested in financial markets. In this way, variable annuities offer the most growth potential of all annuity types, but they also have the greatest market risk. You can lose money in a variable annuity due to market losses.
A fixed index annuity earns interest that is tied to an underlying benchmark index, but this growth potential isn’t guaranteed. However, a fixed index annuity does guarantee the protection of your principal, or original money with which you started your annuity contract. Over time, the annuity tends to earn more interest than a fixed annuity or a MYGA would earn, as the index-linked gains add up. The growth potential of a fixed index annuity is capped in exchange for that benefit of principal protection.
All of these annuities can pay you a guaranteed income for life. Some annuity types come with an add-on benefit, called a rider, that pays you lifetime payouts and still lets you have some access to your money. Other riders may give other benefits. Riders almost always come at an additional fee, and they can be ideal for those wanting more flexibility in their annuity.
The Pros of Annuities for Retirement Income
What sort of advantages can an annuity provide for retirement income? Here are a few ways in which it stands out.
Steady Stream of Income
Annuities are best known for their ability to provide a reliable income stream for life. They are the only thing on the planet besides Social Security that can ensure you receive a steady paycheck, no matter what the market does.
That can bring great peace of mind during retirement. And the means that insurance companies use to manage these obligations of ongoing payments have historically held up well.
Protection Against Longevity Risk
The greatest fear that people have is outliving their money. It’s an understandable concern. The Nobel-winning economist, William Sharpe has called the risk of running out of income the “nastiest, hardest problem in finance.”
With their promise of lifetime income, annuities guard against the uncertainty of living longer than expected (and depleting your funds to zero). That can be a nice benefit when people are living longer with wellness, healthcare, and technology. Among those who are in excellent health and non-smokers, women have almost a one in three chance of living to age 95 or beyond. For people of the same category, men have an almost one in five chance that they will live to 95 or beyond.
As the average lifespan goes up, the ability to shield yourself from this longevity risk with an annuity can be quite attractive. You won’t outlive your savings, and the insurance company is on the hook to keep paying you income for as long as you live.
Guard Against Market Risk
One of the greater risks as you near saying “sayonara” to your career is being in the “retirement risk zone.” This is the period of just a few years before retirement and in early retirement. When you fall into that timespan, investment losses can greatly affect your financial security. If your portfolio takes a hard hit, those losses can add up even more should you already be taking money out of your retirement accounts for income.
Annuities safeguard you against this risk of untimely losses with their guarantee of principal protection.
Diverse Options for Payouts
Annuities come in various shapes and sizes. That gives retirees the ability to customize their annuity according to how they would like to receive payments.
You can turn your annuity money into an income stream that pays you for the rest of your life. This is called annuitization, and one downside is that you can’t reverse the income stream. If you want some liquidity, you can opt for an annuity with an income rider that lets you receive lifetime withdrawals, but the rider will come with a fee.
Your payout options are also flexible. You can choose a joint life payout option that continues payments to your spouse once you are no longer here. Should you want to maximize income during your lifetime, you may go for a single life payout (and provide for your spouse via other features of the annuity).
Say that you don’t need the income for the rest of your life. Your payout options include payment durations for a set amount of years (5-20 years). You can also choose a payout option that has a set schedule and if you pass away early, the payments will continue to your spouse for the remaining span.
On the rider side, you can have fixed payout options, or some riders offer increasing income options, in which your payments grow in various ways. Talk to your financial professional about these payout options and what might make sense for your situation.
The Cons of Annuities for Retirement Income
While annuities are a leader for guaranteed lifetime income, they also have downsides. Here are some trade-offs to keep in mind if you want to explore the complete picture of using an annuity for retirement income.
Annuities can be fairly complicated, and it also depends largely on the type of annuity you are looking at. Some annuities are simple, such as an immediate annuity. Others may have benefits that you would like, such as some access to your money. Fixed index annuities let you have this access by permitting free withdrawals and providing guaranteed lifetime payments via an income rider. But there are lots of moving parts, and the income rider typically comes with a fee.
This may be a turnoff for those looking for simple financial solutions (but who might otherwise benefit from the guaranteed income). It can also take more time for a financial professional to cover more complex options, so that you know what you are getting. Don’t be afraid to ask questions until you are comfortable.
Less Liquidity Than What Other Options Offer
Annuities pay a steady income stream, but they do have less liquidity than other financial instruments. With many investment options, you can sell off assets so that you have liquid funds if you need them. Several savings options may present more liquidity than annuities in general. That is the trade-off that you get for an annuity with its steady, unchanging income stream in market conditions and economic conditions that are good and bad.
That being said, many annuities let you have some money access with free withdrawals. In other words, you can take out up to 10% of your annuity’s contract value each year. Perhaps keep this feature in mind if it’s important for you to have an annuity that will give you some liquidity.
Talk to your financial professional about what else you can use for sources of liquidity, and how you can include them in your overall retirement plan. Your needs for income and liquidity shouldn’t have to conflict with each other.
Annuity Fees and Expenses
Many annuities don’t have any fees or expenses. But not all fall into this camp. Variable annuities tend to have lots of fees and expenses, including administrative fees, mortality and expense charges, rider fees, and fees tied to the subaccounts in which you can invest money.
Fixed index annuities offer add-on benefits in the form of riders: lifetime payments with some money access, enhanced liquidity with free withdrawals, a bigger payout for heirs once you are no longer here, and more. However, these riders often charge an annual fee. The more bells and whistles that you have on your annuity for add-on benefits, the more that you might be paying in rider fees.
Ask your financial professional about the rider options with your annuity, what they do and don’t do, and how much they cost. If a rider benefit doesn’t solve a specific problem in your financial plan, it might be too much. The same goes for having too many riders tacked on to your annuity contract. You should have these details explained well to you before you make a decision.
Guaranteed payments from an annuity may not keep pace with inflation. Especially high inflation. When they turn on income, many annuity owners opt for level payments from their annuity. These payments are fixed, meaning they won’t change over the years. The upside is that they are guaranteed to last for as long as the annuity owner lives.
Over time, inflation eats into money’s purchasing power. If you are receiving fixed payments from your annuity, those payments may be eroded by inflation. Some annuities have increasing-income or inflation-adjusting payout options that can help you keep up with a rising cost of living. Of course, those options have their own nuances as well as pros and cons.
Talk to your financial professional about how you can have other assets in your retirement portfolio that have strong growth potential (and therefore the ability to keep up with inflation). Your annuity income can provide you with a baseline income stream. Then you can use your other retirement assets to help make up for inflation as needed.
Some Final Thoughts on Pros and Cons of Annuities for Retirement Income
Using an annuity for retirement income can be very beneficial. Annuities are the only financial vehicle that can pay you a guaranteed income stream for life. The fact that nothing else can do this is an indicator of what an annuity can do for financial peace of mind.
However, just with anything, there are pros and cons to annuities. The bottom line is that an annuity should be part of your overall retirement income strategy, and it needs to fill an income gap or solve a clear problem in your existing financial plan.
As you weigh the pros and cons, it’s important for an annuity to be tailored to your personal financial situation and retirement goals. Seeking out an experienced and independent financial professional who knows retirement, annuities, and how they tie together can help you in your decision-making process. They can help you explore different options, find annuities that fit your needs well, and determine what is best (if at all) for helping you enjoy a stable and fulfilling retirement.
If you are looking for an independent financial professional to assist you, many are available here at SafeMoney.com. You can connect with someone directly by visiting our “Find a Financial Professional” section and requesting a complimentary appointment. If you would prefer a personal referral, please call us at 877.476.9723.