Although annuities require upfront payments, they do offer an opportunity for tax-deferred growth and ongoing income that can make them a valuable complement to Social Security income during retirement. However, the various ins-and-outs of annuities can be confusing, and because there's a lot to consider before buying an annuity people often make mistakes when doing so.
Mistake #1: Failing to consider all the costs
Unfortunately, many people never consider the fees and commissions associated with an annuity, or the surrender charges, and as a result, they get sold a product that is more costly than a competing product or are sold an annuity that is larger than they need.
Annuities typically charge higher expenses than other investment vehicles and those expenses make annuities one of the most profitable products for financial planners and insurers to market. It's not uncommon to discover that expenses total 2% to 3% annually and that commissions paid to the person selling you an annuity are as high as 10%.
These upfront and ongoing fees can make a big dent in the amount of income you collect over time, but they may pale in comparison to the surrender fees you may have to pay if you need to withdraw money from your annuity within the first few years of funding it. Typically, surrender charges associated with withdrawing money from an annuity in year one are about 7% or higher, and after one year surrender charges usually decline by 1% per year until they reach 0%.
In order to avoid making this mistake, ask what costs and expenses are associated with an annuity and then compare those costs with annuities offered by others, including those sold directly to individuals by insurers.
Mistake #2: Picking a fixed or variable annuity without considering the benefits and drawbacks associated with them
Fixed-rate annuities pay income based on a predetermined rate of return, thus they eliminate the guesswork associated with picking between various investments. Since the rate of return has been previously set, retirees benefit from consistent income unaffected by inevitable market drops; however, that also means that returns for fixed rate annuities may be lower than returns for variable annuities; particularly during periods of economic expansion
If you're considering a fixed rate annuity you should also know that the income paid to you won't increase with inflation (unless it's an inflation-adjusted annuity) and that can mean losing buying power over time. Historically, inflation has increased at a pace of about 3% annually and if that pace continues, a fixed-rate annuity's income payment will cover far fewer expenses in the future than it does today.
Unlike fixed-rate annuities, variable-rate annuities pay out income that changes based on the rate of return earned by the investments owned in the annuity, thus the payments can vary significantly from period to period.
Tying returns to underlying investments, such as stocks and bonds, may help offset inflation risk, but it exposes the annuity owner to market risk if stock or bond values tumble.
Variable annuities can also be more expensive than fixed-rate annuities because mutual funds are usually the investment choices available in a variable annuity and the fees associated with mutual funds are added to other fees you're already paying for the annuity. As a result, investing in a low-cost mutual fund outside of a variable annuity may make more sense, at least in terms of ongoing costs.
Mistake #3: Choosing a payout option that isn't right for your situation
Income from annuities can be paid out in various ways, and making the wrong choice can leave you or your heirs short-changed.
The most common payout choices include income for a guaranteed period, lifetime payments, income for life with a guaranteed period certain benefit, and joint and survivor payments.
If you pick income for a guaranteed period, you'll receive payments for a specific number of years and after that point you won't receive anything. Although payouts for this option can be higher than other options, if you outlive your guaranteed period you'll be left without any annuity income. If you die prior to the end of your guaranteed period, your beneficiary will receive the remaining payments, usually in a lump sum.
Choosing lifetime payments instead of a guaranteed period eliminates the risk of outliving your annuity income payments; however, lifetime payments add the risk of having your insurer profit if you pass away because insurers won't have to pay anything to your heirs after your death
Life with a guaranteed period benefit is a hybrid payment option that pays income to you for life and also can provide income to your survivor if you pass away within a specific period of time. For example, if the period certain period is 10 years and you pass away after five years, then payments will be made to your survivor for the remaining five years.
Joint and survivor payments allow payments to continue to your beneficiary even after you die, providing some level of income security to your survivor.
Also, variable annuities usually include a death benefit allowing your beneficiary to receive an inheritance that is based on the value of the annuity at the time of death, or at another specified period of time. Regardless, an annuity's costs increase when an option or a type of annuity is chosen that allows a beneficiary to receive a death benefit, so keep that in mind when shopping around.
Tying it together
Annuities aren't cheap and that means that people should consider them carefully before buying them; especially if there's a chance of needing the money at some point in the future. In addition to costly surrender charges for withdrawing money, withdrawals prior to 59.5 can result in a 10% tax penalty, plus regular income taxes on any income earned in the annuity.
If you've maxed out other retirement savings plans, such as a 401(k) and IRA, then the unlimited amount that can be set aside tax-deferred in an annuity is intriguing; however, make sure to consult with your accountant first to understand how annuity income might impact your tax situation in the future.
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