Annuities can be an important part of financial planning and a useful addition to some portfolios. But does that mean they should be the first item on an investment list? Probably not. So, the question becomes, when?
“It’s a tough question to answer, because it really depends upon someone’s needs,” said Douglas Collins, a financial planner with Fortis Lux Financial in New York.
What is an annuity?
"Annuity" is a broad term that describes a group of products. In a general sense, they are financial instruments that, in exchange for a lump-sum payment or a series of payments, will provide a stream of payments at some point in the future.
That said, there are many different types of annuities with different benefits and features aimed at accomplishing different things. The question of when to buy one really depends on the individual, their preferences, and when certain needs arise in their financial plan.
- For instance, one broad category of annuities is geared toward building long-term, tax-deferred growth over time, which may make it more appropriate for people with a longer retirement horizon.
- On the other hand, another general group of annuities focuses on providing a guaranteed stream of income either immediately or at some defined point in the future. That may make those kinds of annuities more appealing to those arriving at or close to their retirement years.
In addition, there may be the question of whether an annuity is necessary at all. Between retirement savings, pensions, and Social Security, some people may feel they don’t need the addition of a guaranteed income stream. However, given the overall state of retirement savings and increases in longevity, there are increasing concerns that many Americans will underestimate how much they will need for retirement and outlive their savings. (Related: Uncomfortable truths about retirement)
For those who do fall into the latter group, annuities offer one of the few sources of retirement income that can guarantee income for life. Which type of annuity is appropriate depends on an individual’s circumstances and goals. (Related: Retirement needs vs. RMD rules — and the QLAC)
Longer-term annuity options
As noted above, some types of annuities are designed to help grow savings, on a tax-deferred basis, for long-term goals like retirement.
This group includes:
This category of annuities gives consumers a range of options that help them adjust their risk and growth, based on their time horizon and risk tolerance.
- On one end of the spectrum, variable annuities can provide the full return potential of the market … but are subject to downturns as well. These are appropriate choices for those further out from retirement seeking maximum growth with time to recover from possible losses.
- On the other end of the spectrum, fixed annuities can offer guaranteed interest rates with no exposure to loss. These can be great options for those who are closer to retirement and who need to protect their savings and need to build in some guaranteed returns.
When choosing an annuity from this category that focuses on growth, it will be important to weigh the tradeoffs between growth potential and risk exposure, which typically changes as investors approach retirement. The products also range from being very simple to offering many different features and investment options.
Some of the annuity choices, such as fixed indexed annuities, can be complex and need to work in tandem with other retirement savings plans. Many people opt to consult a financial professional to help navigate the choices.
Other types of annuities focus on providing a guaranteed income stream for retirement. That income can either begin immediately or in the future.
“When you think about it, annuities are kind of like pensions,” said J. Todd Gentry, a financial professional with Synergy Wealth Solutions in Chesterfield, Missouri. “You make payments over time that eventually will add up to an income stream in the future.”
This category of annuities can include:
These annuities are probably best for those immediately approaching their retirement years.
“If you think interest rates are at or near a peak, an annuity may make sense,” said Collins. “In their purest form, annuities pay income based on life expectancy and an interest rate, which is typically set at the time of purchase. Therefore, if we are at a point where interest rates are high, it can be advantageous to lock in that favorable interest rate for life.
“One of the risks associated with fixed income, or bond investments, is reinvestment risk,” he continued. “While it’s great that savers are now being compensated for owning fixed income, they may not be able to reinvest their money at such a rate when those investments mature. For example, a one-year treasury is currently paying approximately 5 percent. One year from now, that investment will mature, and you may not be able to get 5 percent again.”
It’s important to note that the income stream from immediate annuities is derived from paying down the principal invested and interest. Another consideration is that income annuities tend to provide limited or no liquidity, and so while generating guaranteed income is important, it must be balanced with liquid assets to pay for emergencies and unforeseen expenses.
“I wish the modern annuity could be renamed ‘retirement income insurance,’ because that would make the point more apparent that this is a product that, like insurance, has a purpose and a cost,” said Gentry.
Again, these kinds of annuity considerations have to fit into an overall retirement plan and can involve some complicated choices. Many opt to consult a financial professional to help navigate the issues.
In the end, annuities can offer help with many retirement challenges.
“The sum of all retirement plans is that some portion of spending will be for needs, and that’s what you want covered by an income stream generated from an annuity, Social Security, or even a pension,” said Gentry. “That’s where you can get comfort that your everyday needs will be covered. Most people would prefer to only have to spend growth from their 401(k) and other savings balances. Once you spend into principal it can get scary, because you can run out of money.”
But the appropriate choice will depend on the type of annuities being considered in tandem with an individual’s particular circumstances and needs. Understanding the choices is a good first step.
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