Are Annuities a Good Investment?

As you plan for retirement, you may hear about using annuities. Are annuities a good investment, or are you better off avoiding them?

The answer is the same as it is with every other type of investment: it depends whether or not you need the features of that particular investment. So let’s take a look at those features, what they cost you, when using an annuity is (and isn’t) a good investment strategy.

Two Basic Features

Annuities can get extremely complex, so let’s start with the basics. For starters, an annuity is an insurance contract that holds investments inside of it. That may seem unimportant, but it’s helpful to know that almost any investment available inside of an annuity is probably also available outside of an annuity.

And there you have one part of your answer: an annuity is a good investment if you really need the type of investments offered in annuities (namely fixed accounts, which are geared towards conservative investors) and you can’t find a good alternative elsewhere.

Aside from offering fixed accounts, annuities have two basic features that make them unique:

Tax deferral: growth inside of an annuity is “tax deferred.” That means you generally won’t pay income tax on earnings inside of the contract every year. Instead, you’ll wait until you pull funds out of the annuity. Whether or not an annuity is a good investment might depend on the type of tax you pay.

Earnings from annuities are treated as ordinary income (which is generally taxed at high rates for high income earners). That might not be a problem if the money is all pretax money from a 401k or IRA – you’re going to pay income tax on that money no matter what. But if the money is “taxable” money you are giving up the opportunity to pay taxes at long-term capital gains rates, which tend to be lower. You might even be able to earn tax-free income outside of an annuity from municipal bonds, if you’re inclined to use them and your tax situation permits. So, tax deferral alone might not be enough to make an annuity attractive.

Guarantees: annuities usually also offer guarantees of some sort. The most basic guarantee is a promise of lifetime income – if you choose that option the insurance company can pay out your annuity over your life expectancy (with a few twists, if you like). But there are more complex guarantees available. Again, the evaluation of how good an annuity is for your situation depends on what you get and what you have to pay for it.

Note: any guarantee is only as strong as the insurance company that holds your money. Only work with highly-rated annuity providers or you risk losing your hard-earned money.

So far everything we’ve discussed could apply to fixed annuities as well as variable annuities. Fixed annuities might be a good investment for conservative investors (who won’t be hurt by the tax treatment), but you should always compare annuities to other types of investments. By the way, you might wonder what you “pay” to use a fixed annuity. In general terms there are two costs:

  • The rate you earn from the annuity might be lower than you could earn elsewhere (a CD or other investment that is on the conservative side)
  • Flexibility: you typically have to keep your money with the insurance company for a minimum amount of time (5 years, for example, although it could be much longer) to avoid paying surrender penalties
Annuities are good investments if and only if you’re using them for the two features listed above (and if there’s not a better way to accomplish your goals).

More Complex Guarantees

There are other guarantees available as well, which vary from insurance company to insurance company. The fanciest guarantees are only available with variable annuities, which tend to invest your money in riskier investments (which may or may not be a good thing, depending on your needs and how things turn out). What’s more, you usually have to pay additional fees to get access to those guarantees – there’s no free lunch – and those fees can erode your account balance over time.

A few examples of guarantees are listed below.

Death benefit: the insurance company might promise to pay your beneficiaries more than your account is worth at the time of your death.

Hypothetical growth: the insurance company might grow your “hypothetical” account balance at a certain annual rate. You can’t take that balance with you if you leave the insurance company, but you might be able to draw lifetime income based on the hypothetical account balance.

Guaranteed payouts: the insurance company might agree to pay you a certain amount over a certain period of time (not necessarily lifetime income) regardless of how your investments inside the annuity perform.

“High water” locks: the insurance company might take a periodic snapshot of your account value and declare that your hypothetical account balance is the highest (best) of those snapshots. Again, you can’t walk away with your hypothetical balance, but you might be able to draw income against it.

When do (and don’t) Annuities Work?

Annuities work best when they meet a specific need in your retirement plan. They can be good investments if you want to buy lifetime income and you’re willing to accept the tradeoffs that come with using an annuity. For example, you might say

“to reach my goals I need $25,000 of income every year, and this annuity (from a strong insurance company) will provide that for me. I don’t care about growing the money or having flexibility to use it for another purpose. I will account for inflation elsewhere in my plan.”

Even variable annuities can provide peace of mind and an additional way to build (future) retirement income.

However, annuities are not a good investment when they’re poorly understood. They are often “sold not bought” because insurance agents and financial advisors can earn large commissions from annuity sales. If you haven’t examined numerous alternatives, watch out. If you think an annuity is perfect, that means the pros and cons have not been explained in a fair and balanced manner and you’re probably dealing with somebody who does not have your best interests at heart.

If you decide that annuities are a good investment for you, avoid putting all of your assets into them. It’s extremely unlikely that one single investment is all you need. You’re probably familiar with the concept of diversification (don’t put all of your eggs in one basket). That concept is valuable when it comes to spreading your money among different stocks and mutual funds. It’s also a good idea when it comes to deciding which tools and strategies to use for retirement income.