Eileen St. Pierre, The Everyday Financial Planner
Annuities are a popular subject for retirees or those approaching retirement. Retirees are attracted to these investments because they offer a guaranteed income stream for life. In theory, when added to monthly Social Security and pension benefits, annuity payments can boost a retiree’s fixed income. But for many annuity products, the costs outweigh the benefits.
Here is how a traditional fixed annuity works:
- You invest an upfront sum with an insurance company. The insurance agent will get a commission from the insurance company. The average commission is 3.5% (on a $200,000 investment, that’s $7,000).
- The company will invest that money in bonds during an accumulation period (typically around 7 years). Your account will be credited with a set portion of the bond interest.
- After this period is over, the company lets you convert your account into a guaranteed stream of fixed income payments for the rest of your life.
- If you decide to cash out of the annuity early, you will have to pay surrender charges so the insurance company can recoup commissions and other costs that the insurer had to pay upfront. For a traditional annuity, these charges generally start around 7.5% ($15,000 on a $200,000 account) and decline the longer you hold the annuity.
There are other more complex annuity products:
- A variable annuity allows you to control how your money is invested (such as in a stock fund) and your annuity payments will rise and fall along with the value of your account. These annuities charge higher fees than a traditional fixed annuity.
- An index annuity is a fixed annuity that pays interest tied to the performance of at least one stock market index. If the market goes up, your payments will go up. If the market goes down, you will just get the fixed amount. But the insurer will cap how much you can earn in a year, and it is free to change the cap each year to protect its profit margin. These annuities have the highest surrender charges (average around 12.5% but can go as high as 20%). The average commission is also higher, around 6.8%. These are very complex products and consumers have a hard time understanding them (as seen by the number of consumer complaints filed with state insurance commissioners).
If you are worried about outliving your money, want the security of an annuity, but want to avoid the hefty surrender charges, many financial planners suggest this alternative strategy:
- First, put your money in a conservative portfolio (for example, 85% in short-term Treasury securities, 15% in a S&P 500 index fund) until you are ready to draw annuity payments. This gives you the flexibility to withdraw this money without penalty.
- When you are ready to start receiving annuity payments, purchase an immediate annuity. This type of annuity will start paying guaranteed income right away.
- Because you are giving up control of your money at this point, only invest enough to generate the income you need to cover your basic living expenses – you can always purchase an additional immediate annuity later.
- Visit the website http://immediateannuities.com for information on immediate annuities.
With any annuity, make sure you understand how your beneficiaries are affected. Some annuities will continue making payments to beneficiaries for 5, 10, or even 20 years, but these annuities will cost more. In addition, make sure your annuity contains a provision that allows you to take out up to 100% of your money penalty free if you are diagnosed with a terminal illness or enter a nursing home.
This is a big investment decision. Take your time. Don’t rely solely on the word of the insurance agent. Consult an independent financial advisor for help.