The idea of an annuity is simple enough. You give a company some of your savings, and in return they promise to pay you a certain amount of income over a certain period of time.
However, the world of annuities is much more complex than that. There are several kinds of annuities offered by many different companies, and there are certain situations in which annuities make a lot of sense. Here are three of those situations, as well as some things to keep in mind before you decide to go annuity-shopping.
Do stocks keep you awake at night?
Perhaps the most universal reason people are attracted to annuities is the opportunity for consistent, predictable income. This is especially true for retirees, who really can't deal with market ups and downs.
A quick calculation on Fidelity's annuity income estimator shows that as of this writing, a 65-year-old man can purchase an annuity for $100,000 that will pay him $550 per month (an annual total of 6.6% of the original amount) for the rest of his life, whether he lives to 110 years old or dies tomorrow. It would take him about 15 years to recoup his original investment. So an annuity can be quite risky in this way.
However, you can also guarantee a benefit for a certain period of time, such as 20 years. In the above example, a 20-year guarantee would reduce the monthly payment amount to $485, but in the event you die before 20 years of payments, the remaining payments will be made to your beneficiaries.
Now, make no mistake about it: Over long periods of time, you are likely to get far better returns by investing in stocks or high-quality mutual funds. However, the ups and downs along the way can be nerve-racking. With an annuity, you are guaranteed a certain amount of income no matter what the market is doing, how high or low interest rates go, or what else is going on in the economy.
Are you worried about outliving your savings?
A good way to use annuities is to buy some "insurance" to protect yourself if you should outlive your retirement savings by purchasing a deferred-income annuity.
Basically, with a deferred-income annuity, you pay an insurance company some money, and the insurer agrees to pay you a certain amount of income beginning at some future date.
For instance, if you are convinced that your retirement savings will definitely last until you turn 85 but you aren't too certain beyond that, you could buy a deferred-income annuity now that will kick in once you turn 85.
And you may be surprised at how much income you can get. According to a current list of payouts, a 60-year-old man can buy a deferred-income annuity for $100,000 and collect about $4,000 in guaranteed monthly income from the time he turns 85, continuing for the rest of his life. This is an annual rate of 48% of the original investment, thanks to the long delay in receiving payments.
However, there are a few things to be aware of. First, if you buy a deferred-income annuity, make sure you don't use money you're counting on in the meantime. In other words, the money you spend on the annuity is no longer earning returns and can no longer be used for your current retirement expenses.
And if you don't live until the annuity kicks in, the money could be gone, depending on the terms of your particular annuity agreement. That's why deferred-income annuities pay so much; not only is your money sitting in their accounts earning returns until the company has to start paying you, but there are a lot of annuities they will never have to pay at all.
Also, as with standard annuities, there are ways you can buy a "guarantee." For example, in exchange for a lower monthly payout, you can buy a deferred-income annuity that refunds the premium amount to your heirs if you die before the payouts begin.
Is the market giving you a good opportunity?
Right now, interest rates are pretty low on a historical basis, so annuity payouts are also relatively low. And as the Federal Reserve begins to raise interest rates (it will happen eventually), the annuity income rates will begin to rise as well.
So if you're thinking that annuities could be a big part of your retirement strategy and you have a considerable time frame to make decisions, it may be a good idea to wait until interest rates rise. When they do, you'll have the ability to lock in a higher rate of income in perpetuity, no matter what interest rates do after that. If you are close to retirement age when interest rates happen to be high, it may be a smart move to go ahead and lock in a high income rate.
However, be cautious about locking in high annuity rates too early in life. For example, if rates rise considerably when you're just 45 years old and you find an annuity that will pay you income equivalent to 9% of the annuity premium for the rest of your life, you may be depriving yourself of better investment returns from other sources that will help you even more over the long run.
Consider that the average total return of the S&P 500 over the past two decades has been about 9.4%. And unlike an annuity, this is not just an income stream, but rather it is money added to your initial principal, which remains yours. In other words, if you are still more than a few years away from retirement, you're probably better off keeping your money in stocks, mutual funds, or even certain fixed-income investments.
A word of caution
Now, there are a few things you need to be aware of before you start shopping around.
First, you should know that an annuity is only as good as the company that issues it, so you should limit your shopping to rock-solid, well-known companies. Just to name a few, Fidelity, Prudential, MetLife, and Vanguard are big, reputable companies that offer a variety of annuity products.
Further, annuities can be expensive. The fees associated with annuities can vary drastically from one company to another, but these expenses definitely need to be taken into consideration. You'll likely pay (either directly or indirectly) commissions to the salesperson or agent, underwriting fees, and management fees associated with the annuity's investments. You should look into "surrender charges," which you may have to pay to pull out your contributions early. Fidelity offers a pretty complete guide to annuity fees, and it's worth a read if you're considering an annuity for your retirement income needs.
While annuities offer relatively low returns and can come with high fees, there are some situations where they can be a part of a solid investment and retirement plan. As with any other investment, do your research and shop around before you choose one.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.