What You Don't Know About Annuities Could Cost You

If you don't know much about annuities, you may be short-changing yourself, as some of them can serve some of us very well in retirement, delivering reliable income. Tread with caution, though, because what you don't know about annuities can cost you. Here's a quick overview of annuities and their benefits and drawbacks.

Image source: Getty Images.

Annuities 101

An annuity is essentially a contract with an insurance company. You'll typically pay the insurer a sum of money (often a hefty sum), and in exchange, the insurer will commit to sending you regular payments immediately or in the future for the duration of the contract. Many contracts offer payments until the end of your life -- or, if you want, until both you and your spouse have died.

There are many different kinds of annuities, and it's vital to understand the differences because some are generally good and others are rather problematic. Here are the main kinds: 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).

Annuities deliver regular income. Image source: Getty Images.

Why you might want to get an annuity

In an era when pensions are increasingly rare, annuities let you buy yourself pension-like income. How much can you expect to receive? Well, a 70-year-old couple might get around $1,000per month via an immediate fixed annuity for as long as at least one of them is alive for a $200,000 purchase price. That, coupled with Social Security income, can help them stay afloat. A 70-year-old woman who spends $100,000 may get about $577 per month, vs. $641 for a 70-year-old man. (Women will usually receive less because they tend to live longer than men.)

Deferred fixed annuities are also well worth considering, because they can pay you more if you're willing to wait a while before starting to collect. A 70-year-old man who spends $100,000 on a deferred fixed annuity that will start paying when he turns 80 can expect around $1,700 per month.

Annuities can help prevent you from running out of money in retirement, helping you sleep better. They're also good because as we age, we often become less interested in and less able to make sound financial decisions. An annuity takes away much responsibility, letting a retiree just sit back and collect annuity checks each month.

Consider, too, that fixed annuity income takes stock market risk out of the equation: If the market tanks, you're not likely to see any interruption in your payments.

Good annuities can keep you from going broke. Image source: Getty Images.

Dangers and drawbacks of annuities

Of course, annuities have some downsides, too. For example, some particular kinds of annuities, such as indexed annuities and many variable annuities, are problematic and unsuitable for many people, charging steep fees and/or carrying restrictive terms. (Immediate or deferred fixed annuities, though, sport fewer drawbacks and are well worth considering.)

Annuity income is not guaranteed. The insurer does promise to pay you according to the terms of the contract, but that promise is only as reliable as the insurance company that sells it. Thus, 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.

The prevailing interest rate environment should play a role in your annuity decision-making, because when rates are higher, you will be able to get bigger payouts. Many people expect rates to rise in the next few years. If you think they will, you might benefit by delaying an annuity purchase.

Another concern is that there are many people out there trying to sell annuities, and some of them engage in misconduct. A 2016 studyexamined the records of more than a million financial advisors and former financial advisors between 2005 and 2015 and found that 7% of them -- 87,000 in total -- had been disciplined for misconduct or fraud. The top complaints were unsuitable advice (21.3%), misrepresentation (17.7%), unauthorized activity (15.1%), omission of key facts (11.6%), fees/commissions (8.7%), and fraud (7.9%), and the specific productsinvolved in the most misconduct were insurance (13.8%), annuities (8.6%), stocks (6%), and mutual funds (4.6%). It's smart to find out whether your advisor is held to the "fiduciary" standard, which requires offering advice that is in the client's best interest. Non-fiduciaries can get away with simply offering suitable recommendations that may earn them bigger commissions than better recommendations would. You can also just skip the salesperson and contact a trusted insurer on your own. You brokerage might even offer annuities.

Image source: Getty Images.

The big picture

Annuities can provide a significant chunk of your retirement income, but they're not your only option. You can build other kinds of income streams for yourself, such as via dividend-paying stocks. That income is far less guaranteed, but spreading your money across a bunch of solid blue chip stocks can reduce a lot of risk. If you have $300,000 in dividend payers that average a 4% yield, you can collect $12,000 per year.

When planning for your retirement, it's worth considering a fixed annuity, whether immediate or deferred. Don't leave your retirement up to chance or up to Social Security. The average Social Security benefit, after all, was recently $1,350per month, or about $16,000 per year. (The maximumbenefit for those retiring at their full retirement age was recently $2,639 -- or about $32,000 for the whole year.) If you don't expect to receive enough Social Security income to fully support you in retirement, you need to be setting up other income streams.

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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.