Buying an Annuity for Retirement Makes Sense -- Sometimes

By Mark Cussen Markets Fool.com

An annuity can provide a steady stream of income -- but it comes at a cost. Image source: Getty Images.

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The use of annuities inside a qualified retirement plan or IRA has been a controversial practice among financial planners for the past few decades. But new innovations have been added to annuities in recent years, and this has changed the rules of the game in the minds of many planners who once saw annuities as unfit investments for their clients' retirement assets. There are both advantages and disadvantages to taking this approach, and you need to understand these pros and cons before making a decision to use them.

Why to use an annuity

Annuities are unique retirement savings vehicles that allow investors to save money on a tax-deferred basis even if the annuity contract is not held inside an IRA or other qualified plan. Investors can fund these contracts with either a lump sum or with a series of payments over time. The annuity will then pay the investor a stream of income during retirement. The chief reason why financial planners recommend that their clients invest some portion of their retirement savings in an annuity is that annuities can provide guaranteed lifetime income in the same manner as a corporate or government pension. This can be an important guarantee for clients who live to a ripe old age, as they will be able to continue drawing income from the insurance carrier even after they have gotten back all of their original investment plus the interest or growth in the annuity contract. Variable annuities can also incorporate smart money management strategies such as dollar-cost averaging and portfolio rebalancing.

Another major advantage that many annuities offer is a living benefit rider that guarantees a minimum lifetime payout based upon a promised hypothetical rate of growth. If the hypothetical account balance based on this rate of growth exceeds the actual value of your contract at retirement, then your payout will be calculated based on this higher amount instead of your actual contract value.These riders have made annuities more attractive for many investors and advisors because the hypothetical rates of growth that these riders promise are often higher than the rates offered by other types of guaranteed instruments such as CDs or Treasury securities.

The case against annuities

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Despite the advantages of annuities, annuities do have some drawbacks, regardless of whether they are used inside an IRA or qualified plan or not. One of the chief disadvantages is the fees involved. The amount you pay will vary depending upon the type of annuity that you use; there are no fees associated with fixed annuities that simply pay a fixed rate for a set period of time. You will probably pay an annual fee for using an indexed annuity, which is a special type of fixed annuity that pays interest to the contract based upon the performance of an underlying financial benchmark, such as the Standard & Poor's 500 Index. When the benchmark rises, interest is credited to the contract, and when the benchmark falls, no interest is credited -- but the investor doesn't lose anything either. Indexed annuities will also charge an additional fee if you opt to use one of the guaranteed income riders that comes with it.

You will pay several types of fees for a variable annuity,which is a different type of annuity that invests the money that is put into it in a selection of mutual fund subaccounts that will rise and fall with the markets. Variable annuities do not pay a set rate of interest like fixed annuities; the growth in these contracts is based upon the performance of the mutual fund subaccounts. Variable annuity fees include account maintenance fees, fund management fees, and mortality and expense fees. And, as with an indexed annuity, you will also pay an additional charge for any guaranteed living or death benefit riders that you opt to include. And all types of annuities come with back-end surrender charge schedules that will penalize you if you withdraw more than a certain percentage of the contract within the first few years of purchase. Although this schedule eventually falls to zero, it can take several years before it finally disappears.

Furthermore, you cannot roll over your annuity or access the principal in the contract once your guaranteed payout begins; at that point, you have annuitized the contract -- that is, you have irrevocably converted the contract into a payout stream that cannot be stopped or modified for any reason. This rule also applies to all types of annuities. For this reason, many investors choose not to annuitize their contracts because they want to retain control over their money when they retire. This means they will not get the income guarantee, but they can still take out a systematic withdrawal for income.

When it comes to using annuities inside your IRA or qualified plan, you'll need to decide whether you value the advantages that they can provide more than the disadvantages. Despite their fees, indexed annuities may still provide a better rate of return over time than other types of guaranteed investments, so the fees you pay may be worth it. Even fixed annuity contracts typically pay slightly higher yields than CDs or government bonds with very little risk. For more information on whether putting some or all of your retirement money into an annuity makes sense for you, consult your financial advisor.

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