Annuities Explained: Understanding Their Role,
Benefits, and Risks
- Written by: Michael Agorastos, CFP®
- September 12, 2024
Annuities are financial products designed to provide a steady income stream, typically during retirement. They are often used as part of a broader investment strategy to ensure financial security in the later stages of life. While annuities can offer several advantages, they also come with complexities and potential drawbacks that investors should carefully consider.
What Are Annuities?
Annuities are contracts between an individual and an insurance company. In exchange for an upfront payment or series of payments, the insurance company agrees to make periodic payments to the annuitant, either immediately or at a future date. Annuities can be structured in various ways, with the most common types being:
- Fixed Annuities: These offer a guaranteed interest rate and fixed payments. They are considered low-risk since the payout is not affected by market fluctuations.
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- Variable Annuities: These allow the investor to allocate payments to a portfolio of investments, usually mutual funds. The payout varies based on the performance of these investments, making them riskier than fixed annuities.
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- Indexed Annuities: These are tied to a stock market index, such as the S&P 500. They offer a guaranteed minimum return, with the potential for higher returns if the index performs well.
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- Immediate Annuities: These begin payments almost immediately after a lump-sum payment is made. They are typically purchased by retirees seeking an immediate income stream.
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- Deferred Annuities: These begin payments at a future date, allowing the invested funds to grow tax-deferred until the payout begins.
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Annuities can also be categorized based on the duration of the payout:
- Life Annuities: Provide payments for the lifetime of the annuitant, ensuring they do not outlive their income.
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- Fixed-Period Annuities: Provide payments for a specified period, after which the payments stop.
Benefits of Annuities
- Guaranteed Income: One of the most significant advantages of annuities is the guarantee of a steady income stream. This can provide peace of mind, especially for retirees concerned about outliving their savings.
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- Protection Against Market Volatility: Fixed and indexed annuities offer protection against market downturns. Even with variable annuities, some options include guaranteed minimum withdrawal benefits, providing a safety net against poor market performance.
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- Tax Deferral: Annuities offer tax-deferred growth, meaning the money invested in the annuity grows without being subject to taxes until it is withdrawn. This can be advantageous for those in higher tax brackets who expect to be in a lower tax bracket during retirement.
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- Customizable Options: Annuities can be tailored to meet individual needs. For example, they can be structured to provide income for life, for a specific period, or even to include a death benefit for beneficiaries.
Drawbacks of Annuities
- Complexity: Annuities are often complex financial products with numerous features, fees, and conditions. Understanding all the terms and implications can be challenging, even for savvy investors.
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- High Fees: Annuities can come with high fees, including administrative fees, mortality and expense risk charges, and investment management fees. These costs can significantly reduce the overall return on investment.Â
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- Potential Lack of Liquidity: Once money is invested in an annuity, it may not be easily accessible without incurring surrender charges for a certain period of time if you would like to exit the contract.
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- Lower Returns: While annuities offer security, they often provide lower returns compared to other investments, such as stocks or mutual funds. This trade-off between risk and return may not be suitable for all investors.
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- Potential for Inflation Risk: Unless an annuity includes an inflation protection feature, the fixed payments may lose purchasing power over time, especially during periods of high inflation.
How Annuities Fit into an Investment Strategy
Annuities can play a crucial role in a diversified investment strategy, particularly for individuals nearing or in retirement. The key is to understand where they fit and how they complement other investment vehicles.
- Retirement Income Planning: Annuities are often used as a tool for retirement income planning. They can provide a guaranteed income stream that, when combined with Social Security and other retirement savings, helps cover basic living expenses. For risk-averse investors, this security can be invaluable.
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- Diversification: Including an annuity in an investment portfolio can add a layer of diversification. Fixed and indexed annuities, for example, can provide stability and reduce overall portfolio risk, particularly in volatile markets. They serve as a counterbalance to riskier investments, like stocks, which may be more susceptible to market fluctuations.
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- Longevity Risk Management: Life annuities, in particular, are designed to mitigate longevity risk—the risk of outliving one’s assets. By providing income for life, they ensure that even if an individual lives longer than expected, they will continue to receive payments. This feature makes life annuities a valuable tool for those concerned about longevity risk.
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- Estate Planning: Annuities can also be used in estate planning. Some annuities offer death benefits, ensuring that beneficiaries receive a payout if the annuitant passes away before receiving the full value of the annuity. This can be an attractive feature for those looking to leave a financial legacy.
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- Tax Efficiency: For investors seeking tax efficiency, annuities offer the benefit of tax deferral. This can be particularly beneficial for high-income individuals who expect to be in a lower tax bracket during retirement. By deferring taxes until withdrawal, investors can potentially lower their overall tax liability.
Conclusion
Annuities are complex financial instruments with both benefits and drawbacks. They offer guaranteed income, tax deferral, and market protection, but can also involve high fees, limited liquidity, and lower returns. When integrated into a broader investment strategy, annuities can provide stability, help manage longevity risk and ensure a secure retirement. However, it’s crucial for investors to understand the terms fully and consider how annuities align with their overall financial goals and risk tolerance.
Written by,
Michael Agorastos, CFP®
Michael is a comprehensive, fee-only financial planner who began his financial services career with Insight Wealth Strategies in 2013. His primary areas of expertise cover retirement planning (e.g. cash flow analysis, developing retirement income strategies, stock option planning, corporate benefit analysis, etc.), investment planning, and high-level income tax reduction strategies for individuals and small business owners.
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Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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