Experts now predict annuities may play a greater role in retiring clients’ portfolios as people live longer and are looking for “longevity insurance.” There are definitely issues you need to be aware of if you think you may want to purchase an annuity. But for people that want to lock in a “guaranteed” stream of income for their (and their beneficiaries’) lifetime, it may be worth a look as more companies are offering better, low cost options.

Annuities can be “qualified” or “non-qualified.” Qualified annuities are bought with pre-tax dollars (frequently as a result of taking an annuity from a company retirement plan). Non-qualified annuities are purchased with after-tax dollars. This article will focus on non-qualified annuities.

Two Types of Annuities

If you think you may want an annuity, your first decision will be to choose a “fixed” annuity or a “variable” annuity. A fixed annuity locks in the interest rate and payment schedule when you buy the annuity. A variable annuity offers you a choice of underlying investments that will determine how your annuity grows (or decreases) over time before you “annuitize” it and start regular payments.

Social Security is basically a fixed annuity. You get a set amount for life that may increase minimally over time. For some people this stream of income can represent a million dollars in present value. It’s worth taking the time to determine the best time to start taking this benefit and how to coordinate it with a spouse.

Reasons to Buy an Annuity 

  • You want to lock in a stream of income for life. This is often referred to as “longevity insurance.” Make sure the insurance company making that guarantee is sound.
  • You want a Guaranteed Lifetime Withdrawal Benefit that can be purchased with a variable annuity. This feature of a variable annuity comes at an additional cost, but will guarantee that you can withdraw a minimum amount. That could be helpful if the market dropped significantly for a sustained period of time, especially right at the point of retirement. This strategy can also be combined with delaying the start of Social Security benefits. Be careful you understand if the guaranteed payment will be applied against your cash value in the annuity.
  • A deferred annuity can be set up to start later in life and may act as a form of insurance against cognitive decline. It would pay a set amount during the later years when it could be harder to manage one’s own money.
  • You expect to live a long time. It may pay to wait to buy an annuity until after age 80 in this case as a hedge against longevity risk.
  • You can’t control your spending and you need to receive a set amount per month, like a paycheck. You risk depleting your nest egg if left to your own devices with spending.
  • If you don’t want the risk of investing your nest egg in the stock or bond market. If you are concerned about extreme volatility, a fixed annuity may give you peace of mind.

Reasons to Not Buy an Annuity

  • Not as much principal will go to your heirs unless you choose a feature that allows for your “basis” to be paid to beneficiaries or that pays out over a “term certain.” (That just means you buy an option to have the monthly payments continue for a set amount of time even if you pass away.)
  • Taxation of annuities after the first death are complex and can vary from one insurance company to the next. A non-spouse beneficiary may not be able to stretch out payments or have the liquidity that the original owner of the annuity had. It is critical to understand what happens after the first death before you sign the annuity contract.
  • When you annuitize, or start the stream of payments, you lose flexibility of the principal. For that reason, most retirees choose to annuitize only a portion of their nest egg. That allows some principal, outside of the annuity, to be tapped for emergencies.
  • You pay insurance costs and/or mortality costs. Be careful you understand what you will be paying.
  • Any additional features you want to add, like return of premium or term certain payments, cost extra and can take away from how much goes to your heirs.
  • There may not be inflation increases in the payments. If you do want your payments to increase with inflation, you’ll take a lower starting amount.
  • If you think of a fixed annuity as part of your fixed income allocation in your portfolio, you may have to hold more stocks in your “liquid” portfolio. That may mean taking on more risk in the flexible part of your portfolio than you are comfortable doing. If you hold a more balanced mix of stocks and bonds in the non-annuity portion of your portfolio, you may hold a smaller allocation of stocks overall and that may affect the growth of your nest egg over time. Be sure to incorporate that new asset allocation and associated growth level in any retirement projections you do.
  • You can build your own “quasi” annuity by buying Treasury Inflation Protected Bonds (TIPS) and maintain your liquidity. But TIPS may not pay out as much as an annuity and there is no guarantee they will last for your lifetime.
  • If you already have a defined benefit pension plan and/or Social Security, you may not need another annuity.
  • You don’t expect to live a long time. If you die young, unless you take out a feature to extend payments, your annuity will stop.
  • Lower interest rates may negatively affect your payout schedule. (Some expectations about current and future interest rates may already be built into the projected payout plan.)

Disclosures
The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.