Do Annuities Ever Make Sense in a Retirement Plan?
With life expectancies on the rise, many prospective retirees worry that their retirement savings won’t last long enough. Annuities often appeal to anxious investors because of their reliable income stream, yet there’s almost always a better alternative for a retirement plan.
With the recently enacted SECURE Act giving 401(k) plans clearance to include annuities, you may be even more inclined to include one in your retirement plan.
The article covers what you need to know about annuities’ role in your retirement planning.
The Allure of Annuities
Annuities are investment products that are usually considered low-risk, and though the income they provide is often modest, the promise of income for life is a major draw to future retirees.
Since many annuities come with commissions attached, the insurance agents making sales pitches for the purchase of an annuity often capitalize on the fear of running out of money in retirement.
The promise of a commission means that even the most well-meaning of salespeople won’t be looking out for your interest when recommending an annuity. So it is important for you to review any potential annuity contract’s fine print before buying one, as many come with fees and charges while paying you less than you might receive from a diversified investment portfolio.
A Brief Overview of Annuities
When you purchase an annuity from an insurance company, you’ll make either a lump sum contribution or monthly payments. The investment then becomes “annuitized” (or converted) into an income stream. You will receive a set amount of income at regular intervals, usually after a predetermined length of time.
Annuities come in a few varieties, including the variable annuity, which pays you based on your chosen investments’ performance. Depending on how the market performs, your principal could do very well or not well at all.
The fixed annuity, in contrast, comes with a guaranteed rate of return for a fixed number of years.
An indexed annuity is tied to a particular market index, and it pays a fixed rate based on that index’s performance.
The Downsides to Annuities
Annuities don’t end up being the perfect fix-all that some financial representatives and insurance companies make them out to be. Depending on the annuity type, they often come with such downsides as:
Internal fund costs and high fees, which in part pay for the hefty commission the salesperson received. Those costs and fees can include account expenses, underlying investment fees, and surrender charges for taking your money out before a specified time frame.
Annuity caps, or a limit placed on the return of an investment in an indexed annuity over a specified period. For instance, if the market returned 6% but your annuity cap was 3%, your maximum return rate would be 3%.
Participation rates, meaning a certain percentage of the index return that your insurance company credits to your account. For instance, if your annuity’s participation rate was 70% and the market returned 6%, you would receive a 4.2% return (70% of the market gain). And if the market dips and your investment loses money, your participation rate will limit your annuity’s recovery rate once the market starts swinging upward again. That means you won’t enjoy the full benefits of the market recovery.
Most annuity agreements prevent you from withdrawing your money for a specific time period (usually 10 years).If you do withdraw your money, you face the surrender charges mentioned above.
The success of an annuity depends on the success of the insurance company. So if that company fails, your state’s insurance backstop program is the only recourse you’ll have to recoup your losses.
Do Annuities Make Sense in Your Retirement Plan?
An annuity might be the right choice for some investors. For instance, if you already have your retirement savings well in hand and have a surplus you want to direct into an annuity for the added security of a regular payout, an annuity might work for you.
However, you may want to consider working with a fiduciary, fee-only financial advisor to determine your needs. A fiduciary, fee-only advisor like our Roseville, CA financial planning firm is obligated to put your best interest first in making recommendations and won’t receive commissions for the advice they give you. They’ll be able to objectively tell you whether an annuity works for your situation or if a more appropriate alternative exists.
But anyone who is considering an annuity should be aware that they aren’t always the ideal investment that they are made out to be. Downsides of annuities—such as high fees and payout restrictions—generally outweigh their upsides.
Under the SECURE Act, the Department of Labor is requiring 401(k) plan sponsors to provide estimates on how much income an account holder would receive if they converted their balance to an annuity.
Though the number can be helpful in determining your retirement readiness, be sure you understand the assumptions that were used in arriving at that number. They may end up being used to promote the annuity rather than helping you make informed decisions under a range of scenarios.
While there is no definitive rule that annuities are always a bad idea for any retirement plan, it’s a safe bet that you can probably find another solution, such as a properly invested portfolio, to help meet your retirement needs.
In almost all cases, you’d be better served by directly investing in a low-cost index fund. Index funds tend to be lower risk than other stock investments due to their diversification, and they’re likely to provide a much higher return on your investment. You can also speak with a fee-only, fiduciary financial advisor who provides comprehensive investment management based on your goals to determine the appropriate portfolio allocation for your needs.
Schedule a complimentary, 15-minute call with a fee-only, fiduciary financial advisor today to discuss your personal situation.
This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.
Parkshore Wealth Management is a family-owned, independent, fee-only Registered Investment Advisor serving the greater Sacramento area with an office in Roseville, CA. We partner with financially responsible individuals and families who are eager to take positive steps that will allow them to use their money to build the life they desire. The firm is led by Harold Anderson, CFP®, and Daniel Andersen, CFP®, both members of NAPFA, the country's leading professional association of fee-only financial advisors.