Annie Logue of the Root of All, Chicago on the Cheap, and author of several “Money and Investing Dummies” books about asks: “When are annuity investment products a good idea?”
Annuities are a hot-button financial offering because they are a product that usually charges you high fees and nets the seller a high commission. Thus, they are frequently (inappropriately) promoted to individuals for the purpose of giving the seller a fat commission.
This article delves into the nuts and bolts of the annuity product, when and when not to buy an annuity, and how not to get taken when you purchase an annuity.
What is an annuity?
Annuity means a stream of income payments.
Sounds great? Who doesn’t want a stream of money coming into your account every month? But like every other benefit, you must ask, “What is the price I pay to receive this income stream?”
A financial annuity is an investment product which can make retirement more comfortable by generating an income stream, or increase/protect your savings.
Unless you win the lottery (which is less likely than getting hit by lightning), in order to receive the income stream, you need to fund the annuity. Here are the ways you can fund the annuity.
Pay the issuer of the annuity-usually an insurance company:
1. With a lump sum one-time payment.
2. Regular salary transfers to the issuer.
3. Several lump sum payments.
How do you decide what type of annuity to buy?
There are more varieties of annuities than you can imagine. And with the aging baby boomers, more annuity products are created every day. All annuities have an accumulation and distribution phase.
Following is the “Cliff Notes” version of the differences between various types of annuities.
Now or later? Immediate or deferred annuity
When exploring the question, ‘Should I invest in an annuity?’, let’s start with the broad annuity categories. The immediate annuity is the simplest type; investors make a lump sum payment now and begin receiving payments for life (or for a specified period of time).
The deferred annuity has a longer accumulation phase. You pay monies in or fund the annuity for a certain time period, before receiving annuity funds. While the money is being accumulated, it is growing tax-free and may be invested by the annuity company. The withdrawal phase can be structured as a lump sum payout or a monthly income stream.
Annuity drill down
Once you understand the immediate or deferred annuity question, you need to grasp the three different approaches to the annuity: fixed, variable, and equity index annuity. These types of annuities explain both how the payments are calculated and in what type of assets the annuity contributions are invested.
1. Fixed annuity
The annuity owner receives a guaranteed fixed minimum payment, set at the time of purchase.
This sounds great, except if inflation heats up and your $1,000 monthly income payment can only buy $600 worth of goods and services.
2. Variable annuity
The annuity monies are invested in stock and bond mutual funds (usually selected by the annuitant) with the hope of growing the initial contributions more rapidly than they would compound with a traditional savings vehicle.
The payout amount is determined by the growth of the funds during the accumulation phase. This could be risky if the investments don’t perform well. Although, there may be a minimum payout option for this type of annuity-usually a good alternative.
3. Equity index annuity
This annuity combines fixed and variable features. The accumulated funds are invested in a mutual fund representing a stock market index such as the S+P 500, and the annuity value is tied to the indices’ growth. To counteract the possibility of a steep market decline, minimum payout is set and may increase if the index performs well.
If your head is swimming with all of the annuity varieties, you’re not alone. The basic question is is an annuity the right choice for you. If the answer is yes, then you need to figure out what type to buy.
Should I invest in an annuity?
This is a difficult question to answer. Consider that an insurance company is in the business of making money. Thus, the issuer hopes that when all is said and done (and you’re six feet under), the company has received more in funds than they have paid out. Otherwise, the annuity company won’t be in business too long.
Before investing in an annuity, make certain that you are investing as much as possible for retirement through workplace retirement accounts and even a Roth IRA if you’re eligible.
Next, if you like the security of receiving an additional income stream, in addition to Social Security, find out if your 401(k) or 403(b) can be converted into an annuity.
For example, I have a 403(b) account with TIAA from a job I had at San Diego State University decades ago. I currently invest in a stock mutual fund within this account.
At retirement, I have an option to annuitize this account. At that point, I plan on comparing the present value of the account with the net present value of the proposed annuity payments. If it turns out that the net present value of the annuity payments is greater than the value of the annuity, I expect to annuitize the account.
Deciding on whether to purchase an annuity also depends on how long you expect to live. I have a friend, Dylan, whose mom lived until age 90 and whose dad is going strong at age 97. He’s in good health as well. He’s a good risk for an annuity, as it’s likely he’ll receive more in payouts than he pays in.
It’s a calculated decision when purchasing an annuity. The insurance company is betting you’ll die young (and be able to keep more of your payments) and you’re hoping to live a long time.
When deciding whether to buy an annuity, think about these questions:
1. How much are my expected living expenses?
2. What is my expected income; include Social Security and any additional pensions?
3. Is there an expected shortfall between my anticipated retirement income and expenses?
4. Do I have the option to annuitize an existing 401(k) or 403(b)?
5. What is the size of my expected nest egg at retirement? Will the income from my portfolio be enough to supplement my income streams?
6. Do I want the security of knowing I have a lump sum or regular income payments in retirement?
After evaluating your answers to the above questions, you’re better able to decide the answer to “Should I invest in an annuity?”
In general, if you have a shortfall between projected income and expenses in retirement, you may want to investigate an annuity. Additionally, if you would be happier with an additional income stream and either don’t have enough money in investments to add to your income for your entire expected retirement, then you might answer “yes” to the question, “Should I invest in an annuity?”
Caveat: Before you buy an annuity
Understand what you’re buying. The annuity documents are mind-numbing, but force yourself to read them or go to a lawyer for help with the annuity lingo.
Know the fees and commissions you are paying. Avoid buying an annuity with a high commission payable to the seller. There are annuity alternatives to paying a 7% commission.
Only purchase a low fee-low cost annuity, from a reputable issuer. My bias would be to investigate the annuity products at Vanguard and Fidelity. After all, you don’t want the insurance company to go under before you get your income stream.
Finally, I have a friend, Kaitlin, who retired from her physician’s assistant job in her early 50’s.
She had a hefty amount saved up, and she bought several annuities. Now she’s working part-time at a “fun” job and living off of the income streams from her annuities, until her Social Security kicks in.
The annuity takeaway
As with most financial decisions, “Should I invest in an annuity?” is a question which requires thought and evaluation.
If the answer for you is “Yes,” then look at some of the annuity offerings the discount investment brokerages offer; their fees and commissions may be lower.
DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation in writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.
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