How to Decide If a Retirement Annuity Is Right for You

How to Decide If a Retirement Annuity Is Right for You

Financial planning for retirement involves many individual factors, but the goal does not change: to build sufficient assets to last a lifetime. In other words, retirees want to be confident that they will not outlive their money. Many financial products and investments are designed to help accumulate money that will provide a comfortable lifestyle during retirement and freedom from worry about paying the bills. Annuities are one of many options to consider. There are many different varieties of these contracts with insurance companies and several factors to evaluate. It can be confusing, so here is a guide on how to decide if a retirement annuity is right for you.

How Close Are You to Retirement?

Think about how soon you will need payouts to begin. An immediate annuity begins paying out as soon as you purchase it, with a set amount over a predetermined amount of time. It requires a lump-sum purchase. This means you lock up a large amount of money in exchange for a promise of an immediate income stream.

On the other hand, a deferred annuity allows you to add money (tax deferred) over time and allow it to accumulate, earning interest and/or increasing in value based on the underlying investments that make up the annuity, depending on the type of investment.

How Much Income Will You Need in Retirement?

Do you plan to travel, buy a second home, or downsize? Many retirees remain active for decades, and some even take on second careers or start businesses. Most will have several sources of money for retirement, and an annuity may be just one of them. If you already have an IRA, a 401K, or other tax-advantaged retirement investment, an annuity can act as an income supplement. You should also factor in how much you expect to receive from Social Security and when you will elect to begin taking those payments.

Are You Currently in a High Tax Bracket?

Annuities allow you to defer income tax until you begin taking payments. Ordinarily, people expect to earn less money in retirement, and as a result find themselves in a lower tax bracket. Income tax is payable on retirement annuity payouts only when you begin taking them. This means that contributing to an annuity can lower your taxable income now, deferring the tax on that contributed money to the future, when the tax rate on the money may be lower.

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How Comfortable Are You With Risk?

You may often hear that annuities offer “guaranteed” income. This is true to a certain extent, but some kinds of annuities carry more downside risk than others. Consider your timeline when selecting a type of annuity. If you choose a fixed annuity, you will receive a set payout when you begin your income stream. The downside is, because the insurance company has promised to regularly pay you a set amount of money, they typically invest your money in lower-yielding, “safer” investments like bonds. You lose the opportunity to invest in riskier investments that might generate higher returns and compound your money to generate a larger basis for the payouts when they begin.

A variable annuity may allow you to choose a variety of investments (typically mutual funds) that carry greater risk but a higher possible return over time. The value of your investment may decline with market slumps, but it will increase in boom times. Your payout, when it begins, depends on the value of the investments you have chosen and can go up or down (but never below a guaranteed minimum, if your chosen annuity provides one.)

The prevailing interest rates at the time you purchase an annuity are also a factor. If you buy an annuity at a time when interest rates are very low, you may lock in a low rate for the life of your annuity contract. There are ways around this—for example, “laddering,” a strategy where you buy several annuities at different times, to take advantage of times when interest rates are higher.

An indexed annuity is a hybrid product that bases part of your money in investments linked to the performance of a particular index, such as the S&P 500, while another portion goes into a fixed annuity with a guaranteed minimum payout.

What Is Your Family Situation?

Part of deciding if a retirement annuity is right for you involves whether you want the annuity to continue to provide for a spouse or other heirs beyond your lifetime. Some annuities offer survivor benefit options that will keep payments coming for as long as your surviving spouse or heir lives.

Remember, annuities are contracts with insurance companies. Insurance companies specialize in assessing risk, and one of the factors they consider is how many years they expect to pay you an income from your annuity contract. As life expectancies increase, monthly payouts may decrease based on the value of the investments that fund the annuity coupled with your estimated life expectancy. Some companies now offer qualified longevity annuity contracts (QLAC), which are meant to help people who live a long time—in fact, these annuities usually don’t begin payouts until the purchaser (“annuitant”) reaches age 80.

The IRS has rules about how much money you can stash away in some types of qualified longevity contracts. These are annuities that allow you to defer taking required minimum distributions that would otherwise start at age 70½. Retirees who have accumulated substantial wealth and don’t need a full income stream at that age can put in the maximum allowed amount to a QLAC and defer payouts until age 85.

Are You Prepared for an Immediate Financial Emergency?

Annuities carry fees and substantial penalties for early withdrawal called “surrender fees.” If you tie up all your money in an annuity, you risk losing a substantial percentage of that money should you suffer an unexpected setback and need to withdraw your money before your scheduled payouts begin. Management fees and commissions can eat into your annuity’s earnings invisibly unless you keep a careful eye on exactly how the insurance company manages your money.

Most reputable financial advisors will tell you not to put your all your investment eggs in one basket. This, however, leaves you with a dizzying array of investment options for retirement planning. Annuities work best as a supplement to other savings and investments. Independent retirement plan advisors can help sort through the many annuity options available. Work with an agent or broker that complies with the “best interest” rule, where advice is based solely on the customer’s best interests, and not on how great a commission or fee the broker will receive if you purchase any annuity.

How to Decide If a Retirement Annuity Is Right for You

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