Annuities often get a bad rap as insurance products – and often rightly so
Life insurance buys financial protection against your premature death. Here’s the how-to on another insurance that protects you from living too long: the annuity.
Annuities often secure steady cash flow to you during your retirement years through growing invested funds. The payout process is known as annuitization.
Over the years, annuities got a bad rap as insurance products – and rightfully so. Like life insurance, annuities generally sell to the public via a sales force of licensed agents. In many cases, annuities are the wrong vehicle for people, though in some cases an annuity makes sense.
Annuities also get a bad rap because of the pure insurance (longevity) feature they provide – especially pure life annuities, simply a guaranteed income stream that lasts as long as the annuity holder (called the annuitant) is alive.
The downside to this annuity: Once the annuitization starts, the annuitant who dies forfeits the money to the insurance company. These annuities pay the most because you the annuitant assume more of the risk – you might make only a payment or two before your death.
The Details are Important
Annuities come with pros, cons and a huge heap of details, including:
- Mortality credits, or the percentage difference between the agreed upon initial return on your money in a pooled-risk annuity and the actual return on your annuitization once some members of the pool die.
- Tax-deferred annuities allow you to put off paying taxes and don’t eliminate taxes. Your tax depends on when you start withdrawing from an annuity.
- The more complicated the annuity, the more expensive its fees. Cheapest is likely a single-premium annuity you buy at age 65 with your payouts beginning in your early 80s. Variable annuities, payouts of which vary depending on the performance of a related securities portfolio, cost more.
- Annuities lock your money for a set period, typically about seven years. Early withdrawals come with surrender charges that decrease with time. You also lose your money if the insurance company itself fails – a slim chance but a consideration for you after the storied near-collapse of American International Group, a huge insurer.
- Add-ons such as guaranteed living benefit riders, under which for a fee you remain invested as you wish, assured of a minimum benefit base that grows over time.
The Concept Makes Sense
The concept of annuity as life insurance – not a bad concept – hinges on risk pooling, or many sharing the risk in their given pool. The same concept exists in auto and home insurance. Most of us go our entire lives without making a claim for our home burning down, at the same time participating in a pool that insures those whose homes do burn down.
Likewise with annuity risk pools: Those who die early pay for those who live longer. Even Social Security seems a form of annuity, in that an individual could pay into the system for a lifetime, retire and then die after receiving only a few payments.
Annuities are insurance products. Ask yourself, “What am I insuring?”
Answer: your longevity, specifically maintaining a flow of cash during it.
What Should You Do?
Do you need an annuity right now? Depends on your age and your income needs in retirement. Generally, the younger you are, the less you need an annuity as there are many other tax-favored vehicles that can build wealth over time.
Consider additional factors if you’re older. If you receive Social Security as well as a pension – the latter yet another form of annuity – you already partially insure your retirement against outliving your money. Annuities constitute another tool to back up your retirement funding.
Talk to your financial advisor.