Annuities are incredibly popular instruments for retirement planning. They come in all shapes and sizes, and while having more options can be a good thing, it can also be very confusing. For that reason, fixed annuities are a popular way to guarantee income without wrestling with a complicated and expensive product. Even so, buying an annuity is a major decision. To help you weight both sides, here are 10 fixed annuity pros and cons:
Fixed Annuity Pros and Cons:
1) Guaranteed Returns
Since fixed annuities pay you a set amount of interest (like a CD), your returns are guaranteed. This is very useful if you’re concerned about stock market risk as you approach retirement.
2) Guaranteed Income
This is probably the most popular feature of fixed annuities. You hand money to an insurance company via a fixed annuity, and in return the insurance company pays you consistent income for the rest of your life. Your income doesn’t fluctuate due to stock markets, interest rates, or whether your rental property is leased for the month. It’s guaranteed and reliable.
The only reason the insurance company might fail to pay this income is if they went out of business. And even though many of us are skeptical about big companies in the financial industry, insurance companies are very unlikely to go bankrupt. They are regulated by individual states, each of which requires them to keep a great deal of cash on hand to pay their liabilities (far more than bank reserve requirements). Even though fixed annuities aren’t insured by the FDIC, the likelihood that you won’t receive promised retirement income is extremely low.
3) Low Investment Minimums
Another favorable feature of fixed annuities is their low investment minimums. Years ago you might need to invest $10,000 or $50,000 before an insurance company would offer you a premium product. These days the bar is lower. $1,000 is usually plenty to get started with.
4) Tax Deferral
All annuities, fixed annuities included, are tax deferred products. Just like your IRA or 401k, the money you put into an annuity grows tax free until you pull it out. For anyone who’s already contributed the maximum to their IRA and 401k for the year, annuities are a popular way to save additional funds for retirement on a tax deferred basis.
When you start pulling money out of an annuity, your tax burden will be based on an exclusion ratio. This is the relationship between your account value when you begin withdrawals and your cost basis.
5) Flexible Payout Options
- Timing. You can draw income from an annuity now or at any point in the future. For example, many people incorporate longevity annuities into their retirement strategies. With a longevity annuity, you might contribute $100,000 to a fixed annuity on the day you retire, with the expectation that you won’t draw income from it until you’re 85 or 90 years old. This set up is also known as longevity insurance since you create an income safety net in case you live longer than you think you expect.
- Length. You may have heard the term “period certain” in your research. When you begin drawing income from a fixed annuity, you’ll have a few withdrawal choices to pick from. The amount of income you receive is based on which option you choose:
- Straight life: consistent payments each month for the rest of your life.
- Joint life: consistent income payments each month for the rest of you AND your spouse’s lives.
- Lump sum: you can always withdraw your investment in a lump sum if you choose. If you’re considering this option, be sure you’re not incurring surrender charges or a 10% early withdrawal penalty.
- Period Guarantees. Opting for the straight life payout option can be a risky proposition. If you die immediately afterward, your family will have lost the entire amount you put into the annuity. To guard against this possibility, insurance companies offer “period certain” payout scenarios. By electing straight or joint life annuity payouts with period certain, your beneficiaries will receive your income payments if you die within a given time frame. Usually this option is offered over 10 or 20 year increments.
1) Limited Returns & Teaser Rates
Although the returns in a fixed annuity are guaranteed, they tend to be very low. In fact, it’s usually not difficult to produce higher returns by building a relatively safe bond portfolio.
Also many insurance companies will include “teaser rates” in their fixed annuities. This means that they’ll guarantee an attract return for a short period of time, but then reduce it after a few years. From that point on, you’d be stuck with the same low return unless you backed out of the policy.
In any event, fixed annuities are not a vehicle for growth.
2) Fees, Commissions, and More Fees
All annuity policies have built in fees that cut into your return. But of all annuity policies, fixed annuities are normally far less expensive than their more complicated cousins (index and variable annuities). Here are the fee’s you’ll encounter:
Surrender charge: Most policies will incorporate some type of surrender charge. This means that if you surrender the policy within a certain time frame, the insurance company will incur a fee. Surrender charges normally decrease the closer you come to the end of this period.
M&E charge: There are also mortality & expense, and administration fees in annuities. With fixed annuities, these charges are usually “baked in” to the interest rate you receive on your account balance. If a policy offers you 4% returns and charges 1% in annual fees, your net returns will obviously be 3% per year.
Commissions: Finally, annuities are normally sold as commission products. That means that an advisor or insurance representative recommending a product may well receive a commission if you choose to buy from them. While a commission won’t come “off the top” of your account balance (it’s paid by the insurance company) it does mean you need to take this relationship into account. While most professionals are reputable people genuinely interested in helping you, some will do whatever is necessary to collect the commission.
3) Loss of Flexibility
No list of fixed annuity pros and cons would be complete without the mention of financial flexibility. All annuities have an accumulation period and a withdrawal period. The accumulation period begins when you purchase the policy. Your account balance will grow at the stated rate of interest, and when you decide to take income from the policy, the accumulation period will end and the withdrawal period begins.
During the accumulation period, you have some flexibility with the policy. Specifically, you may surrender the policy and withdraw the balance in the event of an emergency. There may be surrender charges and early withdrawal penalties involved (some of which can be avoided if you swap policies in a 1035 exchange). But you can get out of the contract and get most of your money back if you really need to.
Once you begin the withdrawal period, you don’t have the same flexibility. The insurance company will pay your income each month, but in the event of an emergency you don’t have the same freedom to redeem the policy for cash. The insurance company owns your principal investment. You only own the income stream.
4) Limited Inflation Protection
Standard fixed annuities will pay you a fixed dollar amount each month once you begin withdrawing from the policy. The problem for retirees is that your cost of living will creep up slowly over time due to inflation. Over the course of a 30+ year retirement, this will be quite a lot.
For example, let’s say a fixed annuity pays you $1000 per month and inflation averages 2% per year throughout your retirement. 30 years from now, your monthly annuity payments will only be worth $552.07 in today’s dollars.
Now, remember that annuities come in all shapes and sizes. And there are many products on the market today that will offer inflation protection, meaning that your monthly income payments will increase over time along with inflation.
The drawback is that inflation protection tends to be very costly. If a standard fixed annuity pays you a consistent $1000 per month throughout retirement, the same fixed annuity with inflation protection might only pay you $750 to begin with. Thus, fixed annuities have somewhat limited inflation protection.
5) Loss of Step Up in Basis
For most of your assets, like real estate or stocks & bonds, your beneficiaries will enjoy a step up in basis after you die. Let’s say you own shares of Microsoft that you bought many years ago for $20 per share. Microsoft has appreciated and split many times since then.
If you sold your shares today, you’d owe tax on the long term capital gains – the difference between the sale price and what you paid for them originally (your basis).
Once you die, your basis resets for your beneficiaries. Rather than inherit your cost basis from years ago, your beneficiaries will have a basis of the market price around the time of your death. This reduces their tax liability if they decide to sell their inheritance, and is known as a step up in basis. For estate planning purposes, this can be immensely beneficial.
Fixed annuities (and annuities in general) have no such step up in basis. Any gains that you realize in a fixed annuity will be taxable. Even worse, it’ll be taxable as ordinary income to the beneficiary and won’t enjoy favorable long term capital gains treatment.
My Take on Fixed Annuity Pros and Cons
A lot of financial people out there categorically despise annuities.
I’m not one of them.
BUT, I do think that most annuities are incredibly expensive and a poor choice for most people. Any time insurance companies combine insurance products with investment products, it tends to be good for the insurance company and bad for you.
Fixed annuities do not have this issue. They are a plain vanilla product. You hand money to an insurance company, and in return they pay you interest and monthly income for the rest of your life.
You can’t outlive this income and it doesn’t change when the market crashes. The opportunity cost of this guarantee is financial flexibility and growth potential. And because fixed annuities are so straightforward, they’re one of the least expensive ways to guarantee retirement income.
For that reason, they’re one of the few types I recommend to my clients.