By Chris L. Meacham, CPA,
Preparing for retirement is a priority when making decisions about how to invest your money. Annuities are one of the financial products sold with the aim of giving a person a steady cash flow during their retirement years. An annuity is a product sold by insurance companies designed to grow funds from an individual and then convert that investment into a series of periodic income payments. There are different kinds of annuities with varying kinds of risks, such as fixed, variable and deferred. Although annuities can be the right product under the right circumstances, in general, because of their cost, risk, and complexity, we usually recommend staying away from them.
Today, annuities are expensive. Compared to the 50 basis points they cost 10 years ago when the insurance industry was trying to attract annuity investors, today annuities generally cost investors 200 basis points to receive the guaranteed pay out. Also, attractive contractual additions—such as upfront bonuses and appealing income rider percentages— often come with additional annual fees for the life of the policy.
Annuities are also risky. Many insurance companies, for example, only guarantee 87.5 percent of the premiums you pay plus 1 to 3 percent interest, which means if you don’t receive any index-linked interest you will lose money. Even if an agent plugs in some numbers and comes up with an annual projected growth number for the accumulation value, it’s important to realize that this projection is not guaranteed. These numbers are based purely on a theoretical estimation of the stock market’s growth. In fact, even if you have a fixed annuity that promises that you’ll get your money back after 10 years in the stock market, due to inflation, that money will probably be worth less.
Because annuities are so complex, consumers buy them without fully understanding them. For example, people are drawn to annuities because they offer certain safeguards for their principle and regular payments, but because they don’t fully understand how they work, people find themselves with their money tied up and are unable to access it without incurring big penalties.
Despite their pitfalls, some annuities do have their place in certain retirement portfolios, but this decision should not be made without a full understanding of how annuities work.