Are Annuities a Good Investment?

An annuity is a financial contract established with an insurance company, designed to provide a steady stream of income. This arrangement is often utilized as a component of a comprehensive retirement income strategy.

Understanding Annuity Fundamentals

Annuities typically operate in two distinct phases. The initial stage is the accumulation phase, during which an individual contributes funds to the annuity contract. These contributions can be made as a single lump sum or through a series of payments over time. During this period, the money within the annuity grows on a tax-deferred basis, meaning earnings are not subject to income tax until they are withdrawn. This allows the investment to potentially compound more rapidly over time.

Following the accumulation phase is the payout phase, also known as annuitization, when income payments begin. These payments are typically taxed as ordinary income as they are received. For non-qualified annuities, funded with after-tax dollars, earnings are generally taxed first upon withdrawal. If funds are withdrawn from an annuity before the contract holder reaches age 59½, the taxable portion of the withdrawal may be subject to an additional 10% IRS penalty tax.

Exploring Annuity Structures

Annuities exhibit significant diversity in their structures, each designed to meet different financial objectives and risk tolerances. Fixed annuities offer a guaranteed interest rate for a predetermined period, providing predictable growth and income payments. The principal investment in a fixed annuity is also guaranteed by the issuing insurance company, offering a measure of security. Interest rates for fixed annuities can sometimes exceed 6%, with contract terms typically ranging from one year to ten years.

Variable annuities, in contrast, allow the contract holder to invest in various subaccounts, which are similar to mutual funds. The value of a variable annuity and its payout amounts fluctuate based on the performance of these underlying investments, meaning there is potential for higher returns but also for losses. This structure introduces market risk that is not present in fixed annuities.

Indexed annuities, often referred to as fixed indexed annuities, blend features of both fixed and variable annuities. Their returns are linked to the performance of a specific market index, such as the S&P 500, but they include mechanisms like participation rates, caps, and floors. These features mean that while gains are typically limited by a cap, the principal is protected from market downturns, ensuring it will not fall below a certain level.

Annuities also differ in their payout timing. Immediate annuities require a lump-sum payment and begin providing income payments almost immediately, usually within one year of purchase. These are suited for individuals who need an income stream to start right away. Deferred annuities, however, include an accumulation period where the funds grow before income payments commence. This allows the investment to grow over a longer period, making them suitable for those planning for future retirement income.

Assessing Annuity Characteristics

When considering an annuity, it is important to assess various characteristics that influence its overall value and suitability. Fees and charges are a significant consideration, as they can impact net returns. Common fees include administrative fees, which cover record-keeping and account services. Variable annuities also commonly have mortality and expense (M&E) charges, compensating the insurer for insurance risks assumed. Additionally, underlying subaccount fees within variable annuities, akin to mutual fund expense ratios, are common.

Surrender charges are penalties applied if funds are withdrawn early from an annuity, especially during an initial surrender period, which can last from six to ten years. Beyond insurer-imposed surrender charges, early withdrawals before age 59½ may also incur a 10% federal income tax penalty on the taxable portion. Annuities are generally considered illiquid investments, meaning access to funds can be restricted and subject to penalties.

Annuities offer various income payout options that determine how and for how long payments are received:
Single life payout: Provides income for the lifetime of one individual, with payments ceasing upon their death, often resulting in higher periodic payments.
Joint life payout: Extends payments over the lives of two individuals, typically a spouse, with payments continuing after one person’s death, though often at a reduced amount.
Period certain option: Guarantees payments for a specific number of years; if the annuitant dies before this period ends, payments continue to a designated beneficiary for the remainder of the term.
Life with period certain option: Combines these, providing lifetime payments but guaranteeing them for a minimum specified period.

Annuity contracts may include various guarantees and optional riders, often for an additional cost. A Guaranteed Minimum Accumulation Benefit (GMAB) rider ensures that the annuity’s value will reach a specified minimum amount after a holding period, even if market performance is poor. A Guaranteed Minimum Withdrawal Benefit (GMWB) rider allows the contract holder to withdraw a set percentage of their initial investment annually, regardless of market fluctuations, providing a consistent income stream.

Inflation protection is another characteristic to consider, as fixed annuity payments can lose purchasing power over time due to inflation. Some annuity contracts may offer optional riders that provide cost-of-living adjustments to help mitigate this erosion. Finally, annuities can include death benefits, ensuring that beneficiaries receive remaining funds or guaranteed payments upon the annuitant’s death. The taxation of these death benefits depends on whether the annuity was purchased with pre-tax (qualified) or after-tax (non-qualified) funds.