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Read This Before You Get an Annuity

People who buy annuities, it turns out, live longer than people who don't, and not because the people who buy annuities are healthier to start with. The evidence suggests that an annuity's steady payout provides a little extra incentive to keep chugging along. -- Steven Levitt, SuperFreakonomics 

It's hard to top Steven Levitt's reason for buying an annuity -- because it might help you live longer. But choosing to buy an annuity (or two) is not a slam-dunk decision. Here's a closer look at what you need to know about annuities and how they might increase your future financial security by providing critical retirement income -- and how they might hurt you.

Image source: Getty Images.

Annuities 101

Buying an annuity is a lot like getting yourself a pension. At its heart, an annuity is a contract between a buyer and an insurance company. You pay the company a lump sum (or installments) and in return you receive payments, now or later. The payments are often monthly, but can be quarterly, annually, or even a lump sum. The payments can last for a fixed number of years or for the rest of your life. Pay a little extra (or accept smaller checks) and you can have your payouts last until the end of your spouse's life, too, and/or be adjusted to keep up with inflation over the years.

There are lots of different kinds of annuities: immediate vs. deferred (paying you immediately vs. starting at some point when you're older), fixed vs. variable (certain payouts vs. payouts tied to the performance of the market or part of the market), lifetime vs. fixed period (paying until death or paying for a certain span of time), and so on. Some annuities, such as indexed annuities and many variable annuities, are problematic and unsuitable for many people, due to steep fees and/or restrictive terms. But whether they're immediate or deferred, fixed annuities are smart options for many retirees and those approaching retirement.

Image source: Getty Images.

Why avoid indexed and variable annuities?

So what's so bad about indexed annuities and many variable annuities? Well, remember that annuities are not simple arrangements; they have lots of details and terms to consider and decisions to make. Many people considering variable annuities are doing so because some salesperson has urged them to -- perhaps without disclosing the commission or reward he or she will get for selling one.

Variable annuities generally have an accumulation phase, where the money you paid grows, and a payout phase, where the company cuts you checks. The money that you pay in is often invested in mutual funds, with the expectation that it will grow over time. Variable annuities do have some appealing features, such as:

  • Tax-deferral. Your money in one grows without being taxed. It's taxed later, when you withdraw funds.
  • Income for the rest of your life! That sure sounds hard to beat, as it can help you avoid running out of money in retirement.
  • A "death benefit." Some variable annuities will let you choose a beneficiary to receive a certain sum should you die before you receive all guaranteed payouts or if your account's balance is above a certain level.

Another apparent upside of variable annuities is that they give you more control than fixed annuities. You get to choose how the money in your account is invested -- conservatively, aggressively, or somewhere in between -- so if your choices turn out well, you can end up with bigger checks come payment time. Of course, there are no guarantees, and you're also exposed to the risk of investments underperforming, leaving you with less than you'd hoped or planned for.

Variable annuities are often very expensive, with steep fees and costs. A variable annuity will probably charge you fees for mortality and expense risk, along with general administrative fees. In addition to that, the securities you invest your annuity money in, such as mutual funds, will charge fees of their own. These fees add up, making many alternatives to variable annuities look better in comparison. The average annual variable annuity fee (its "expense ratio") was around 2.3% as of last year, but they can top 3%. That will reduce your investment's performance significantly. A $100,000 investment will grow to $215,893 at an annual rate of 8% over a decade, but will only reach $174,080 growing at 5.7% -- fully $42,813 less!

Meanwhile, an indexed annuity (which is sometimes called a fixed indexed annuity or an equity index annuity or a variation of one of those) is linked to the performance of an index, such as the S&P 500 stock index, which is a common measure of the overall U.S. stock market, representing about 80% of it. You could invest in the S&P 500 easily via an inexpensive index mutual fund such as the Vanguard Index 500 (VFINX) or via an exchange-traded fund, such as the SPDR S&P 500 ETF (SPY), which would give you returns that closely track the index. But if the S&P 500 dips or plunges, so will your investment -- though over long periods it has always recovered and gone on to new heights. That volatility scares some people, so they're happy to hear about indexed annuities, which often promise them no chance of losing money or a guaranteed minimum return.

But if you read the fine print on indexed annuities, as you should always do before investing in anything, you'll see that while your downside is indeed limited, so is your upside. Your gains are constrained in a variety of ways. For starters, there's the "participation rate," which measures what portion of the underlying index's return you might receive in your investment's return. Imagine that the S&P 500 was the benchmark, for instance, and it gained 10% in a year. If your participation rate was 100%, the participation component of your investment's return would be 10%. If it were 80%, you'd be credited with 8%.

That might seem pretty good, considering that you're promised little or no losses in the investment. But wait! There's more. There's a cap. The cap is a strict limit on how much you can earn. If the cap is, say, 7%, then even in a year when the S&P 500 surges 20% or 30%, you'll earn no more than 7%. It gets worse, too. There are annual fees, often subtracted from the return, and they can make quite a difference.

The folks at Fidelity crunched some numbers to show how performance-limiting indexed annuities can be. They point out, for example, that in 2013, the S&P 500 surged about 30% (32%, including dividends), while a representative indexed annuity delivered just 10%. They also looked back at the decade ending in 2013, and found that the overall S&P 500 averaged an annual gain of about 7.4%, while the annuity averaged 3.2%. (In many years, the annuity returned 0%.) That's a hugely meaningful difference. A $10,000 investment that grows for a decade at 7.4% will become $20,400, while growing at 3.2%, it will only become $13,700.

Image source: Getty Images.

Focus on fixed annuities

For the reasons above, fixed annuities, whether immediate or deferred, are likely to serve you best. Their fees will often be lower (and fewer), and their value less uncertain.

How much can you expect from a fixed annuity? Well, prevailing interest rates will influence how much insurers will be willing to pay you, and these days rates are very low. Still, even in today's environment, you can buy significant income. Here's the kind of income that various people might be able to secure in the form of an immediate fixed annuity in the current economic environment:

Person/People

Cost

Monthly Income

Annual Income Equivalent

65-year-old man

$100,000

$544

$6,528

70-year-old man

$100,000

$622

$7,464

70-year-old woman

$100,000

$585

$7,020

65-year-old couple

$200,000

$937

$11,244

70-year-old couple

$200,000

$1,029

$12,348

75-year-old couple

$200,000

$1,167

$14,004

Source: immediateannuities.com.

Note that women will generally be offered lower payouts because they tend to live longer than men.

Annuities can serve you well if you're worried about depleting your nest egg and running out of money late in life. Remember that fixed annuities can start immediately or be deferred. If you think you have sufficient income for about 20 years, you might buy a deferred annuity today that will start paying you in 15 or so years. That way, you'll be assured of income later in life too. Better still, you'll get bigger payouts if they're deferred, because the insurance company gets your money early and can invest it for itself until it has to pay you. As an example, a 65-year-old man with $100,000 could recently buy an annuity that will start paying him almost $2,000 per month for the rest of his life beginning at age 80.

Annuity income is guaranteed, as long as the insurance company behind it is solvent. You should always favor top-rated insurers, and perhaps even divide your annuity-buying money between several of them. Look for high marks from credit rating agencies. Here are the top ratings from the major agencies:

Agency

Top Rating

Second-Best

Third-Best

A. M. Best

A++

A+

A

Fitch

AAA

AA+

AA

Standard & Poor's

AAA

AA+

AA

Moody's

Aaa

Aa1

Aa2

Source: Securian.com. 

Other ratings can be pretty good, too, and don't necessarily require disqualification, but you should favor insurers with very high ratings for maximum safety. You might also divide the amount you want to spend on an annuity into several chunks, using them to buy smaller annuities from several highly rated insurers. Know that a big insurance company might have several subsidiaries, each with its own rating. So be sure to find and assess the rating for the entity that will be issuing your annuity.

Image source: Getty Images.

Alternative income

Finally, remember that an annuity isn't your only option. You can generate annuity-like income from a portfolio of bonds that pay interest and/or stocks that pay dividends. There are lots of healthy stocks with dividend yields of 3%, 4%, 5%, and more, and even a simple, broad-market index fund sports a dividend payout that recently yielded 1.9%. Here are some familiar names and their recent yields:

Company

Dividend Yield

Dominion Energy

3.9%

General Electric

3.8%

Cisco Systems

3.6%

Sanofi 

3.4%

Procter & Gamble 

3%

Source: Yahoo! Finance.

If you have a $300,000 stock portfolio with an average dividend yield of 4%, it will kick out $12,000 to you each year. Better still, healthy and growing companies tend to increase their payouts over time, so your income will offer some inflation protection. (Though, of course, dividends are never guaranteed – which is why you want to favor solid and growing companies.)

The average Social Security benefit, as of June, 2017, was $1,369 per month, or about $16,000 per year. That's not going to be enough income for many people, and it will likely be insufficient for you, too -- so give some consideration to fixed annuities, which offer income in retirement.

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Selena Maranjian owns shares of General Electric and Procter & Gamble. The Motley Fool owns shares of General Electric. The Motley Fool recommends Cisco Systems and Dominion Resources. The Motley Fool has a disclosure policy.