This article was updated on December 15, 2017. It was originally published on April 27, 2015.
"People always live forever when there is an annuity to be paid them."
Receiving regular pension checks throughout retirement is a dream most Americans have long given up on. There will likely be Social Security checks, but those generally can't fund a very comfortable retirement by themselves. Fortunately, despite the iffy reputation of some types of annuities, some are worth considering. If you're wondering what's so good or bad about annuities and whether one might be right for you, read on.
Types of annuities
Let's first define our terms. With an annuity, you'll typically fork over a large sum of cash to an insurance or investment company. In return, you'll receive regular payments over time or a lump sum at a later date. Annuities come in a wide variety of forms:
Immediate vs. deferred
You can buy annuities that start paying you immediately or ones that will start paying at some defined point in the future. Deferred annuities generally cost less because the insurance company gets to hold on to your purchase money for a while before paying you anything, and it can invest that sum, profiting from its growth. Deferred annuities are sometimes called "longevity insurance" and are designed to begin paying you later in life -- e.g., beginning at age 75 or 80. Thus, they can help prevent you from running out of money.
Fixed vs. variable
Fixed annuities feature fixed interest rates or fixed payouts, and the income they generate is very predictable. (In low-interest rate environments such as the one we're in now, the monthly payments you buy will tend to be smaller than they would be if you bought when interest rates were high.) Variable annuities, meanwhile, will tie the annuity's payout to the performance of the overall market or some other basket of securities.
Lifetime vs. fixed period
Some annuities will pay you for the rest of your life, sometimes even paying your spouse until he or she dies, too. Others are designed only to pay you for a certain period, such as 10 or 20 years. You can also get a policy that will pay out a fixed sum for a fixed period of time regardless of how long you live, so that if you die before the end of the term, your beneficiaries will be able to collect the remaining payments.
Single premium vs. multiple premiums
When you purchase a single-premium annuity, you make one large deposit with the insurance company. If that's not an option for you, or just not your preference, you can buy an annuity over time via multiple payments. The key difference is that when you pay a single premium, you can start collecting immediately, whereas if you pay over a longer time frame, you generally won't start collecting until you've finished paying.
Single owner vs. jointly owned
A single individual (of any marital status) can buy an annuity that's just for him or her. But couples often choose to jointly own annuities so that when one partner dies, the other will continue receiving payments until both partners have passed away. Everyone's situation is different, but it can be smart for a couple to buy a joint policy instead of two solo ones. As an example, imagine a 70-year-old man married to a 70-year-old woman in Massachusetts. According to an online quoteestimator, the man might be able to buy a fixed immediate annuity offering lifetime monthly income of about $622 for $100,000, whereas his wife might receive $581 for the same premium due to her longer expected lifespan. Meanwhile, a joint $200,000 policy might pay them about $1,021 per month as long as one of them is alive. The solo policies may seem preferable as they total much more, but if one partner dies early, then the survivor will be living on a lot less, so joint policies are worth considering.
What's good about annuities
Here are some of the advantages of annuities:
- They can generate valuable income in retirement, and -- best of all -- if you opt for a lifetime annuity, you'll keep receiving those payments for the rest of your life. This is very reassuring for many people who worry about running out of money.
- They don't have contribution limits, unlike many retirement accounts such as IRAs and 401(k)s. You could spend half a million dollars or more on an annuity if you had the money and wanted substantial regular income.
- If you choose to pay extra, or accept lower payments, many annuities will raise your payouts to keep up with inflation. That can make a big difference, as purchasing power erodes significantly over decades.
- Lastly, annuity income can be preferable to income generated through a stock portfolio where you have to make decisions regarding when and what you should buy and sell. That's because as you age, you'll likely be less able to manage your money or perhaps you will be less interested in doing so. Annuity income takes the work out of it and just keeps paying you.
What's bad about annuities
A strike against annuities is that they tend to lock your money up. With bank accounts and stocks, you can withdraw funds or sell shares to free up cash whenever you want. With most annuities, you'll pay a hefty "surrender" fee if you take your money out too soon. It's not unheard to be charged 7% -- and sometimes as much as 20% -- if you pull your money out within the first year, and then smaller percentages in each successive year for a few years.
Many annuities are sold by brokers who collect fat commissions for doing so, and some commissions have been as high as 10%! If you don't see a commission fee broken down for you, that doesn't mean it's not there -- so ask about it. It may simply be baked into the annuity's operating costs, which you're charged for. You can avoid this problem by buying directly from a company or insurer that offers annuities, bypassing the salesperson.
Speaking of fees, many annuities charge annual fees. This is most common among variable annuities, and it's one of the main knocks against them. It's not unusual to pay between 2% and 3% per year. By comparison, managed mutual funds often charge around 1% to 1.5% per year, while many exchange-traded funds (ETFs) charge 0.50% or less. If your annuity is averaging a 7% annual return but charging you 3% per year, you're losing a lot of ground. Keep in mind, too, that on a $100,000 investment, a 3% charge amounts to a whopping $3,000 per year! With variable annuities, you often get to choose how your money is invested. But remember that what you're doing is a lot like selecting mutual funds, and you could always pay far less to invest directly in funds, cutting out the annuity middlemen. Be especially careful with "indexed" annuities, as many people believe they have more downsides than upsides. You can generally minimize fees and complexity by opting for a fixed annuity instead of variable or indexed ones that are more problematic.
Finally, consider that if you buy a lifetime annuity for just yourself and you have not paid extra for a minimum number of payouts, it's possible that you could die long before you recuperate your significant investment. Money that might have gone to heirs will instead remain with the annuity company. Still, for many people that's a risk worth taking.
What to do
You can bypass the undesirable aspects of annuities if you do your homework and choose wisely. For example, you can avoid the relatively high fees and unwelcome terms of many variable annuities by opting for fixed annuities. You can avoid commission charges by buying your annuities through companies that sell them directly, without having salespeople flogging them for commissions. (Many major low-cost brokerages offer no-commission annuities, for example.) Fixed lifetime annuities are especially worth considering, as they can deliver a lot of peace of mind in retirement.