What is an annuity?

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In a Nutshell

Annuities are investment plans that can provide set payouts in retirement, whether for your entire life or a limited period of time. But they’re often mired in steep fees and confusing rules.
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Unless you’re a billionaire, making sure you have enough money to save through retirement can be a tough proposition.

That’s why there’s a whole host of different savings accounts, investment options and other financial products, like annuities, designed to help fit the bill.

Providing regular income, annuities can be one piece of that retirement puzzle. But they’re often maligned because they can be confusing enough to irritate even the most dedicated planners. Still, annuities can be very useful in the right situations.

We’ll break down the basics so that you can decide whether annuities are worth investigating further or aren’t quite right for your needs.

What is an annuity, exactly?

An annuity is a retirement financial tool. Unlike many retirement tools, though, annuities are contracts between you and an insurance company, rather than with banks or investment companies.

You can buy an annuity in two ways: either by making a lump-sum payment to the insurance company or by paying into it regularly (say once a month). As you give the insurance company money, it may invest it (depending on the type of annuity), although usually at a rate lower than what you could potentially earn by investing in stocks and bonds.

When it comes time to retire, you can choose to “annuitize” the plan, which will switch it from its “accumulation period” (when you pay in) to its “amortization period” (when you get paid). For some annuities, you can receive these regular payments throughout the rest of your life, and maybe even into the life of a beneficiary.

“When I’m meeting with clients, a lot of people will be like, ‘Oh, annuities suck, but pensions are cool or great,’” says Doug Oosterhart, certified financial planner and founder of LifePoint Planning. “And I’m like, ‘OK, well, in the most simple form, an annuity is basically a pension that you buy.’”

Easy enough, right? Well, the details are where annuities can get tricky.

What are the different types of annuities?

In general, there are three basic types of annuities.

  • Fixed annuities guarantee that you’ll earn a certain amount of interest (usually less than you could earn in the stock market or with mutual funds), but also offer a guaranteed payout.
  • Variable annuities allow you to choose your risk level with different investment options. Choose wisely, because you could receive a substantial payout — or lose the money entirely — depending on the investment option you select.
  • Indexed annuities earn a return pegged to a market index (commonly the S&P 500) so that if your annuity performs well, your monthly payout in retirement could be higher.

In addition, various annuities start paying out at different times.

  • Immediate annuities start paying you back within a year after purchase, so they can be a good option to buy during retirement.
  • Deferred annuities start paying you back at a later point specified in your contract — for example, after you’ve already paid into it for many years, as if it were a retirement savings account. While immediate and deferred annuities are both tax-deferred, with deferred annuities your money can grow tax-deferred for longer because you won’t pay the IRS until you receive the money as income down the road.

So what are some of the pros and cons of annuities?

The disadvantages of annuities may seem to outweigh the advantages, but let’s take a look.

Annuities: The Good

It’s easy to worry about running out of money in retirement. After all, many people will need hundreds of thousands of dollars (if not more) to sustain themselves for a long, happy retirement.

But what if you plunked down a portion of your retirement savings in return for a guaranteed monthly payment for the rest of your life, and possibly even your policy beneficiary’s life if you choose? That’s what many annuities promise. It sounds tempting, right? Unfortunately, there are a lot of downsides.

Annuities: The Bad

Once you put money into an annuity, it can be difficult to get it back. That’s one of the huge downsides of annuities: Once the terms for distribution are set, it’s generally out of your hands.

“It pays you a string of income, which is good,” says Oosterhart.

But if you find yourself in a financial emergency, like facing unexpected medical costs or job loss, you might not be able to access that money, or it might be too expensive to do so.

Annuities: The Ugly

Annuities can have notoriously high fees, sometimes up to 3% or more per year. Compare that to a retirement account at an investment company. For example, the investment company Vanguard doesn’t charge an annual account service fee for a traditional IRA as long as you have at least $10,000 in your account (and a fee of only $20 for each account with less than $10,000).

Annuity contracts may hit you elsewhere, with fees for actions like withdrawing your money early and adding on riders (additional policies that allow you to customize your annuity). The insurance company may even include administrative fees.

All these fees can add up to considerable confusion. For many people, the worst thing about annuities is just how darn complicated they can be to understand. There are enough policies, fees, terms, benefits, exclusions, riders, investment options and waiting periods to drive anyone away.

Unfortunately, because annuities include so many terms, there’s an added risk that you’ll sign up for something you don’t fully understand. And if you don’t fully understand every detail of what you’re signing up for, it’s possible that an annuity can hurt your financial situation more than it helps.

Should annuities be a part of your financial plan?

That’s a complicated question that depends on your individual situation. But there are some general guidelines that financial professionals use.

“I’m not a big fan of using [annuities] for younger people,” says Oosterhart. “I would say that they’re more for those on the cusp of retirement or entering retirement. It allows them to have a part of their portfolio that is in line with fixed expenses.”

What does that even mean? Oosterhart gives a good example.

“One of my clients owes $10,000 a year in property tax. So we said, ‘OK, well, if we know that bill comes in every single year, why don’t we just make sure we cover that?’”

Oosterhart advised his client to purchase an annuity that pays out $10,000 per year.

“We tried to line up their fixed income [an annuity] with their fixed expenses [property taxes] in retirement.”

What type of financial adviser should I hire to help me decide if an annuity is right for me?

We recommend choosing a fee-only financial adviser. Your adviser should help you choose the best annuity for your situation — if that even is the best option. If an adviser is steering you toward an annuity you are not comfortable with, you don’t have to move forward. Ultimately, you want to find a product that works best for you.

Bottom line

Like any financial tool, annuities have their place in some people’s plans. But because they can be confusing and convoluted, we don’t recommend setting one up on your own. Instead, consider a fee-only financial planner and maybe even a tax adviser to help you nail down your retirement plan, including what kind of annuities, if any, should be a part of it.

About the author: Lindsay VanSomeren is a freelance writer living in Kirkland, Washington. She has been a professional dogsled racer, a wildlife researcher, and a participant in the National Spelling Bee. She writes for websites such a… Read more.