Please ensure Javascript is enabled for purposes of website accessibility

The Biggest Fear About Annuities, and How You Can Avoid It

By Dan Caplinger - Sep 26, 2015 at 8:00PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

This feature of annuities draws the most scorn, but there are ways around it for those who want.

Photo credit: Ryan Melaugh via Flickr.

Annuities have been around for decades, and even though some policymakers who focus on retirement planning believe that greater annuity use would be a positive for many retirees, the anticipated uptick hasn't come to pass. One key reason for the reluctance among retirees to use annuities has to do with how annuity contracts are structured, and specifically, the idea that you can spend thousands on an annuity and end up having all that money disappear at your death is disturbing to most retirees. Yet insurance companies are never shy about offering ways to get around problems with their products, and there are several options you have to ensure that you can leave at least some legacy after your death. Let's look more closely at why so many people shy away from annuities and the options you have to address a key risk.

The historical downside of the traditional annuity
An immediate annuity is a useful tool, allowing you to exchange a fixed amount of money for the guaranteed right to receive regular payments for the rest of your life. Immediate annuities are one of the best products to address longevity risk, or the risk of outliving your money, because their payments are usually based on a standard life expectancy. If you live longer than the average person, then an immediate annuity will be a good deal for you.

The problem, though, is that the reverse situation has an unattractive result. If you die shortly after starting an immediate annuity, you may end up having received far less in regular payments than you paid up front. With newer products known as longevity annuities or deferred income annuities, which are typically designed to kick in late in retirement at age 80 or 85, you can easily end up getting nothing at all from an annuity if you die prematurely.

In order to address this problem, insurance companies usually allow you to select different options when you annuitize a contract and start receiving annuity payments. They include the following:

1. Picking a survivor.
Many couples use joint-and-survivor annuities to ensure that even after one of them passes away, the other will keep getting payments. The amount of the payments are therefore based on the joint life expectancy of both named beneficiaries, and so you'll get less each month but usually get a larger number of payments over the course of the annuity's payout.

2. Choosing a minimum term for payments.
Another option most insurance companies offer is a guarantee that an annuity will make payments for a minimum length of time after purchase. For as long as you live, payments go to you, but if you die before the term ends, then the beneficiaries you choose can receive any remaining payments. Typically, you can combine traditional annuity features with this option if you choose, so if you live longer than the minimum term, you'll still get payments throughout your lifetime even after the term ends.

3. Opting for a death benefit.
Insurance companies will usually let you choose among death benefits for a chosen heir to receive after you die. One popular choice involves paying out an amount equal to whatever the annuity owner paid in premiums but had not yet received back in monthly payments. These death benefits can be paid in a lump sum or over time, but the net impact is to soften the financial blow when someone dies shortly after annuity payments begin.

Don't get a nasty surprise
One thing to keep in mind with all of these options is that they will affect how much income you receive. The more protection you build in against a premature death, the more money the insurance company will reserve to cover those contingencies, leaving less to go toward your regular benefit payments. In addition, pay attention to any fees that your annuity company might charge for various options.

Nevertheless, if building in the reliable income that annuities provide is of value to you, then taking a closer look at your options to avoid a quick loss of your annuity investment makes sense. You might find it's worth accepting smaller payments to provide for loved ones after you're gone.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/27/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.