What is an annuity, and is one right for you?
Securing a steady stream of income is a key part of any successful retirement strategy. Predictable cash flow is indispensable in your golden years.
Sadly, corporate pensions that provide reliable monthly payouts are increasingly less common. And in this low-interest-rate environment, “high-yield” savings accounts offer only about 1.2% in annual returns, according to Bankrate.com.
That will get you only $1,200 a year on a $100,000 portfolio — not even enough for groceries!
So where should a prospective retiree turn for a reliable source of income in retirement? Increasingly, the answer is to look at annuities.
What is an annuity?
Annuities are best thought of as a kind of hybrid insurance policy and income-generating investment.
Ross Goldstein, managing director of New York Life’s investment group, calls them a “risk-pooled mortality product” — which is a fancy way of saying that a group of people each pay in, and “whoever’s here next year will get a distribution from that pool.”
Of course, the fine print defines the terms of how much you pay in and how much you get out. The main variations of annuities include:
Immediate vs. deferred: An immediate annuity starts paying you right away after you make a one-time, lump-sum payment. In contrast, a deferred annuity involves you paying in, but then waiting a predetermined period of time to receive any payouts. Deferred plans pay more when they do pay out, however, to offset the risk that you may die before collecting any benefits.
Fixed vs. variable rate: A fixed annuity is a guaranteed payout you’ll get each year, while a variable-rate annuity can see benefits fluctuate significantly based on how premium payments have been invested. Variable rates do have the risk of producing smaller payouts if underlying investments don’t perform well, but the potential for bigger payments is worth the risk to some people. After all, fixed annuities have their own risks — for instance, thanks to inflation, a $1,000 monthly payment might not go as far in 10 or 15 years as you think it will.
“Cash refund” or life: A “cash refund” is the non-morbid way annuity providers refer to a death benefit. Under this option, your heirs are guaranteed some or all of your remaining payouts at your passing. Of course, the death benefit to your heirs means you get smaller annual payouts during your lifetime. An annuity for life is simply that — one that pays out until you die, and no longer.
And whatever the strategy or size of your annuity, annual benefits will also vary based on typical mortality factors — your health, your age, even your gender, because women typically live longer than men.
The upsides of annuities
Annuities are an increasingly popular tool for investors planning for retirement thanks to the guarantee of some sort of income stream. In fact, according to the Insured Retirement Institute, U.S. annuity sales reached a staggering $229.4 billion in 2014.
“As people are living longer and longer, they are concerned about outliving their income in retirement,” says Ray Caucci, senior vice president of product management at Penn Mutual Life Insurance Company. “Annuities are a great vehicle for those who want to ensure that won’t happen.”
As one dramatic example, Goldstein notes that New York Life has a policyholder who purchased an annuity in the 1980s … and is still collecting.
“She put in about $100,000, and we’ve paid her more than $800,000 since,” he says.
The downsides of annuities
There are limitations to an annuity. For starters, annuities are not liquid. Once your money is in, typically the only way to get it back is slowly through benefit checks.
Another major risk is the fact that annuities can be quite complicated and opaque.
“There are so many different types of annuities and a lot of complexity — and a lot of that is by design, if you want to be cynical,” says Scott Puritz, managing director of retirement services firm Rebalance in Bethesda, Md.
It’s hard to get at the underlying fee structure because of this complexity, but Puritz says his math puts it around about 3% to 4% in annual costs for the typical annuity.
By comparison, Morningstar estimates that costs across all mutual funds and exchange-traded funds averaged just 0.64% in 2014.
The raw costs themselves are disturbing, but the lack of clarity in cost structures and fees makes shopping around difficult.
“There’s not transparency around costs, and therefore consumers cannot make informed decisions when they are purchasing,” Puritz says.
Perhaps the biggest risk of all, however, is pursuing the promise of security at the cost of growth. Countless research shows that Americans are woefully underprepared for retirement — and what little cash they do have saved needs to be put to work, so it can build over time to a meaningful amount.
Puritz warns that traditional “conservative” strategies of decades past might not cut it for those who are living longer — and frankly, those who are not saving enough for retirement. “Prudent” investment, as he calls it, with an eye toward growth will serve you far better than the illusion of security.
“Without exception, the No. 1 mistake we see in our practice is people being too conservative for their own good by a lot,” Puritz says.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks.
Different Annuities, By the Numbers
How much you get out of an annuity each year can differ greatly depending on when you start paying in, whether you want a death benefit, and a variety of other factors. Here are a few sample payout rates provided by New York Life as examples of how policies may vary based on your terms:
Single Premium Immediate Annuity for a 72-year-old female
- Premiums – $100,000 paid in one lump sum
- Benefits – $7,265.40 annually, or $6,348.12 with a “cash refund” or death benefit
Deferred Income Annuity for a 58-year-old female, with 9-year deferral until age 67
- Premiums – $100,000 paid in one lump sum
- Benefits – $9,893.88 annually, or $8,570.76 with death benefit
Deferred Income Annuity for a 48-year-old female, with 18-year deferral until age 66
- Premiums – $5,000 premium each year for $85,000 in total
- Benefits – $8,384.76 annually, or $7,386.84 with death benefit
Source: New York Life