3 Stupid Annuity Moves

By Selena Maranjian Markets Fool.com

Most of us don't have pension incomes to look forward to in retirement, and Social Security isn't likely to provide enough on which to live comfortably. Thus, it's up to us to save and build future income.

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Annuities are great ways to essentially buy yourself a pension -- just be sure to not make some common errors when getting an annuity. An annuity can be a powerful retirement income generator, but annuity mistakes can be very costly.

An annuity is when you buy future income -- potentially a lot of it. Image source: Getty Images.

Annuities 101

First, though, let's review just what an annuity is. It's a contract with an insurance company or financial services company. You generally pay a sum of money (often a large sum) and in return, the company promises to send you regular payments. Many contracts offer payments until the end of your life -- or, if you want, until both you and your spouse have died.

Here's the kind of income various people might be able to secure in the form of an immediate fixed annuity in the current economic environment:

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Person/People

Cost

Monthly Income

Annual Income Equivalent

65-year-old man

$100,000

$560

$6,720

70-year-old man

$100,000

$655

$7,860

70-year-old woman

$100,000

$600

$7,200

65-year-old couple

$200,000

$958

$11,496

70-year-old couple

$200,000

$1,051

$12,612

75-year-old couple

$200,000

$1,216

$14,592

Data source:immediateannuities.com.

Women can generally expect lower payouts because they tend to live longer than men. And a joint policy will pay less than two separate policies for each member of a couple, but when one spouse dies, the surviving spouse will enjoy higher payouts from the joint policy than from the single remaining policy.

Image source: Getty Images.

Stupid annuity move No. 1: Choosing the wrong kind of annuity

Note that there are many different kinds of annuities, such as: immediate vs. deferred (paying you immediately vs. starting at some point when you're older), fixed vs. variable (certain payouts vs. payouts tied to the performance of the market or part of the market), and lifetime vs. fixed period (paying until death, or paying for a certain span of time).

Fixed annuities are generally preferable to indexed annuities and many variable annuities, as those tend to be problematic and unsuitable for many people, charging steep fees and/or carrying restrictive terms. Variable annuities feature more feesthan fixed annuities, and together, they can take a big bite out of your investment. A typical annual fee (for expenses, administration, management, and insurance) might approach or top1.5%, meaning if your account is worth $100,000, you could be forking over $1,500 more annually! No less an authority than the Securities and Exchange Commission haswarned, "For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity." Indexed annuities, meanwhile, also feature major drawbacks, such as capped returns. If your annuity bases its return on the S&P 500 and features a 4% cap, the S&P 500 might surge 20% in a given year, but you'll only get a 4% gain.

Fixed annuities are generally simpler, with clearly defined -- and fixed -- benefits, along with fees that tend to be lower.

Image source: Getty Images.

Stupid annuity move No. 2: Not considering a deferred annuity

Whether or not an immediate fixed annuity seems likely to serve you well, consider deferred fixed annuities, too, as they can be especially good at helping you avoid running out of money. Sometimes referred to as longevity insurance, a deferred annuity is a fixed annuity, but one that doesn't start paying immediately. Instead, the insurer agrees to start paying at a specified future point, such as 10 or 15 years later. For example, a 70-year-old man might spend $50,000 for an annuity that will start paying him $839per month for the rest of his life beginning at age 80, or $1,589 per month beginning at age 85.

If you think you have sufficient income for about 20 years, you might buy a deferred annuity today that will start paying you in 15 or so years. That way, you'll be assured of income later in life, too.Better still, you'll get bigger payouts if they're deferred, because the insurance company gets your money early and can invest it until it has to pay you -- and because it expects to make fewer payments to you, since you'll be older when being paid.

A deferred annuity also offers peace of mind, freeing increasingly elderly recipients from having to manage their own money -- especially when they may be less able or less interested in keeping up with their investments and making financial decisions. The checks will just start coming and keep coming.

Image source: Getty Images.

Stupid annuity move No. 3: Not choosing your insurer carefully

Finally, remember that annuity income is not 100% guaranteed. The insurer does promise to pay you according to the terms of the contract, but that promise is only as solid as the insurance company that sells it. Thus, it's important to seek out the best-rated insurers and perhaps divide your purchase money between a few of them. For example, if you were going to spend $300,000 on annuities, you might buy a $100,000 contract from three different highly rated insurers. In the unlikely event that one runs into trouble, only a portion of your nest egg will be at risk.

Consider alternatives, too

Remember also that while annuities can provide considerable retirement income, they're not your only option. You can build other kinds of income streams for yourself, such as via dividend-paying stocks. That income may be far less guaranteed, but spreading your money across a bunch of solid blue-chip stocks can reduce a lot of risk. If you have $200,000 in dividend payers that average a 4% yield, you can collect a meaningful $8,000 per year. Dividend-paying stocks can be a nice complement to annuity income.

The average Social Security benefit was recently $1,360per month, or about $16,000 per year. If you don't expect your Social Security income to be enough, consider other income streams, such as annuities.

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