What’s the Price of an Annuity’s Guaranteed Returns?
As stocks drop and prices rise, there’s a lot of talk about annuities.
Some people speak about annuities like they’re the answer to all your problems.
Others think it sounds too good to be true.
It’s fair to be skeptical about any financial thing that has a guarantee.
We’ll look at a few good points and words of caution as you consider them for your financial plan in just a moment.
First: what exactly is an annuity?
An annuity is primarily an insurance product—so they can give a guarantee based on the money coming in from participants. Like life insurance or any other kind of insurance, you will get what’s in your contract.
Every annuity also has two phases. In the first phase (accumulation), you have your part to play. You pay—all at once or over a period of time—a premium for your annuity. The more you put in, the more you get out.
In the second phase (annuitization), the company upholds its end of the bargain: it gives you the agreed upon amount each year.
The structure seems simple enough, but there are multiple types of annuities with a ton of options, and not every agent sells every type of annuity. It’s in this multitude of options that things can get confusing, and people can make assumptions that aren’t true..
The benefits of an annuity
First of all, the most obvious benefit is that the annuity is a contract. If you pay your premiums as promised, the company has to return to you whatever rate was agreed upon.
Thanks to the financial market of early 2022, a lot of people are feeling emotional about their savings. The pain of losing a year’s worth of gains is real.
An annuity rate might not get as high as the highs of a stock market. But a stable, guaranteed return can be a good alternative…especially in a world where most employees don’t receive a pension and have to rely on Social Security for guaranteed income.
What’s in the contract depends on how you build your annuity.
First, you can choose between an immediate or deferred annuity.
Immediate, as you might guess, means you pay one big lump sum premium, and they immediately start paying out for the length and amount agreed upon.
Deferred, on the other hand, means that you let the money grow with the company for a while before switching to the second phase.
There’s flexibility in how long they pay you, too—a certain number of years or for life.
And how do they determine how much to give you? That’s variable as well.
There’s a few basic types of annuities:
- Traditional Fixed Annuity: The simplest option. In the contract, the company will agree to a set amount your money will increase each year.
There will be a minimum rate, and the rate may change after a set period of time—but all these details will be in the contract.
And when Federal interest rates increase, fixed annuity rates usually do, too. That can be a good thing when the rest of the economy is cooling down as interest rates increase.
- Fixed Index Annuity: In many ways similar to the traditional fixed, fixed index annuities still provide some minimum gain.
Unlike traditional ones, the maximum interest rate you can earn depends on some stock market index, like the S&P 500. But because there’s a maximum cap, you won’t necessarily benefit as much as investing in a strong year.
And the minimum interest rate might be 0%, so in a year when the stock market crashes, you don’t gain any money in your account. But you won’t lose anything, so the contract protects you. (The typical minimum rate is 1-3%)
Overall it might be a good choice for someone willing to take a little more risk for a little more reward. There’s a few different ways that a company can use to calculate your index gain; be sure to ask which way a company’s using.
- Variable Annuity: Offering the most risk and reward, the variable annuity doesn’t have the guarantee the others do.
The insurance company still might guarantee certain things, like agreeing to pay out at least what you put in, but any increase is up to the stock market. You can even lose money.
And don’t forget the riders.
We won’t go into all the options here, but each of these annuities can also be customized by ‘riders,’ additional terms in the contract above and beyond the standard terms.
Riders can provide protection for making sure your heirs get something, if any money is left, or helping you pay for Long Term Care costs. Smart Asset compiled a list of some of the most common annuity riders.
Ultimately, there’s a lot you can put in a contract to get the most out of an annuity, protecting you from how much you don’t know about your future.
A few annuity warnings
As with all financial and insurance products, they’re not for everyone.
Get an expert to look at your unique situation to see if locking your money into an annuity makes sense and always, always read the fine print.
Some of the drawbacks include…
- Complicated contracts. Yes, everything is in the contract, but that doesn’t make it easy to read!
- Not getting your money’s worth. It can be easy to make an assumption that heirs will get some sort of payout…but that all depends on what’s in the contract and the riders. If you just entered the second phase, got your first payment, and passed away, the company may get to keep what’s left.
And of course with each protection you add with a rider, the cost of the annuity goes up.
- Money’s locked in. If you put $100,000 into an annuity, you better not need that back! There are steep surrender charges in the first few years—a surrender charge being what it takes to break the contract.
In a down market, you’ve already lost a chunk of your retirement savings. If you put your funds into an annuity, you might get less back than if you left your money in the market. Be sure to carefully review your budget, know what you need to live, and consider whether putting this money aside makes sense.
Your annuity should come with a ‘free look period,’ a brief period where the contract has started but you can still cancel the contract without penalty, but it doesn’t last long.
- Locked in at phase 2. Once you start phase 2—annuitization, where you receive your money—that’s it. You can’t go back to accumulation, and you get what you get as outlined in the contract.
- Fees and commissions. Depending on the contract (as always!), your annuity might have higher fees and a steeper commission than other investment and insurance vehicles. It might still work for you in the long term, but be alert.
- Taxation at normal income rates. Whereas long-term investments are taxed at a more generous capital gains rate, annuities (just like IRAs) are taxed at your current income bracket when you take money. Don’t underestimate those taxes.
Annuities can work in the right plan
Annuities can be an amazing, safe way to know your income in retirement.
But like every piece of a financial plan, what’s great for one person might not work for you.
Make sure you get all your questions about your annuity answered before you agree to the contract, and don’t assume anything about it.
But the peace of mind from having that guarantee is worth a certain cost.
