The Pros and Cons of Annuities

By Markets Fool.com


Annuities can deliver regular installments of income. Image source: Pixabay.

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Just about all of us will need income in retirement, and one source of it that many of us overlook is annuities. Annuities can provide very dependable dollars for long stretches of time -- even for the rest of your life -- but they're not without some drawbacks. Let's review the pros and cons of annuities, so you can better determine whether they might make sense in your overall retirement plan.

Defining terms
Let's first understand exactly what we're talking about. Buying an annuity typically involves paying a significant sum to an insurance or investment company in exchange for their promise to make a series of payments to you over time. There's quite a range of annuities:

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 keep your money for a while before paying you anything, so it can invest and grow it. They're also called "longevity insurance" by some, as they're designed to begin paying you later in life and can help prevent you from running out of money when you're old.

Fixed vs. variable: Fixed annuities feature fixed interest rates and/or fixed payouts and predictable income. In low-interest rate environments such as the one we're in now, the monthly payments you buy will tend to be smaller than if you bought when interest rates were high. Fortunately, we seem to have begun a period of rising rates, which is good news for fixed annuity buyers. Variable annuities, meanwhile, tie the performance of the annuity 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, perhaps even paying your spouse until he or she dies, too. Others are designed to only pay you for a certain period, such as 10 or 20 years.

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Data source: Annuityve, Wikimedia Commons.

Single premium vs. multiple premiums: A single-premium annuity involves your depositing a big check with the insurance company at one time. If that's not an option for you, or just not your preference, you can buy an annuity over time, via multiple payments.

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 one, so that when one partner dies, the other will continue receiving payments until both partners have passed away.

The pros of annuities
Here are some of the pros of annuities:

They can generate valuable income in retirement, and -- best of all -- if you opt for a lifetime annuity, you will keep receiving those payments for the rest of your life. This is a very reassuring big deal for many people who worry about running out of money. As an example, a 70-year-old man might receive, for $100,000, about $640 per month for the rest of his life -- that's $7,680 per year. With $300,000, he could get $23,000 annually, which is a meaningful sum.

If you choose to pay extra (or accept lower payments), many annuities will increase their payouts to you to keep pace with inflation. It's smart to add that feature, as purchasing power erodes significantly over decades. If inflation averages 3% over 20 years, it can cut your purchasing power in half!

Annuity income can be preferable to income generated through a stock portfolio for at least two reasons. For one thing, it's much more of a sure thing. It's also appealing because managing your own investments as you get older takes time and skill, and as you age you'll likely be less able to manage your money or perhaps less interested in doing so. Annuity income spares you a lot of work and just keeps paying you.

Annuity income can help you sleep at night. Just buy wisely. Image source: Tambako the Jaguar, Flickr.

The cons of annuities
Annuities are not perfect, though. You can add and remove money from lots of investment accounts, but when you buy an annuity, that money is generally gone. (You may be able to get much of it back, if you pay a hefty "surrender" fee.)

Many annuities are sold by brokers who collect fat commissions for doing so, with some commissions as high as 10%! If you don't see a commission fee broken out for you, that doesn't mean it's not there. It may simply be baked into the annuity's operating costs, for which you're charged. You can avoid commission charges by buying your annuities through companies that sell them directly. (Many major low-cost brokerages, for example, offer no-commission annuities.)

Many annuities charge annual fees. This is mostly a feature of variable annuities, and is one of the knocks against them. It's not unusual to be paying between 2% and 3% per year. For context, managed mutual funds will often charge around 1% to 1.5% per year, while ETFs (exchange-traded funds) will often 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'll 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 can always just invest directly in funds for far less, cutting out the annuity middlemen.

A final consideration is that if you buy a lifetime annuity for just yourself and have not paid extra for a minimum number of payouts, it's possible that you could die within a year or two, having received very little for your significant investment. Money that might have gone to heirs will instead remain with the annuity company. Still, that's a worthwhile risk to take, for many people.

You can bypass many of the drawbacks of annuities by researching the topic further and making smart choices. For example, you can avoid the relatively high fees and unwelcome terms of many variable annuities by opting for fixed annuities. Fixed lifetime annuities (including deferred annuities) are well worth considering, as they can deliver a lot of peace of mind in retirement. Don't just leave your retirement to chance -- or merely to Social Security. (The average Social Security benefit is only about $16,000 per year.)

The article The Pros and Cons of Annuities originally appeared on Fool.com.

Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article.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.