An old saying among investors is that annuities aren’t bought, they’re sold. This is because annuities often are very complex, very expensive financial products that carry heavy commissions for the advisers who sell them.
Unfortunately, that saying is frequently very, very true.
Annuities are insurance products that are frequently marketed for their investment-like features. In general, the more complicated a product is, the more expensive it winds up being — either through direct costs and fees or through cases of “the large print giveth, the small print taketh away.”
As a result, if you’re considering an annuity, your best bet is to keep yourself focused on why you need the annuity and what features of that annuity really matter to you.
Why buy an annuity?
The best reason to consider buying an annuity is because you have money set aside for your retirement but have no interest or ability to manage that money. For instance, if you’ve worked your entire career without thinking about investing, and then you get a lump-sum distribution from your retirement plan at work, you might be a candidate for an annuity. Alternatively, if your spouse always took care of the household finances but is no longer able to, an annuity may be right for you.
Still, even if you fit into one of these categories, you should know what you’re getting into and the downsides of even the best-designed annuity. For one, it’s only as good as the financial strength of the insurance company issuing it. If the insurance company goes bankrupt, you’re at the mercy — and limits — of the state’s insurance-guarantee program for any potential recovery.
For another, in most cases, annuities promise to pay you for a certain amount of time — and that’s it. Frequently, that amount of your time is either for your life, the longer of your life or your spouse’s, or a specific calendar duration. If you want to leave an inheritance to your children, your alma mater, or your favorite charity, you either can’t do it with your annuity or it will cost you significantly to do so.
The simplest is usually the best
In most cases, the simplest form of annuity is the best to buy — the one known as a single premium immediate annuity. As the name implies, you make a one-time investment in the annuity and the annuity company begins immediately (or possibly, the very next month) paying you a monthly income. A key reason these annuities are often the best is because they’re the simplest, and thus the easiest to compare across providers.
Because single premium immediate annuities are so easy to comparison shop, annuity companies often offer solid and competitive deals on those straightforward plans. Part of their hope is to establish their reputations for “fair dealing” with their customers, and then upsell you on a more complex (and likely profitable for them) offering.
The big benefit for you is that you can turn your lump sum of cash into a reliable, predictable income stream that can potentially last the rest of your life. A key thing to watch out for, though, is that as soon as you get beyond a plain vanilla contract — such as adding inflation protection, second-to-die rights, or a guarantee your estate will get back at least what you paid into it — the costs start adding up. The insurance company knows that most annuity buyers want those features — and is happy to charge to provide them.
In a similar vein, you often can find a reasonable deal on another form of straightforward annuity known as a single premium deferred annuity. With this type of annuity, you also make a one-time investment and the annuity starts paying out that monthly income at some agreed-upon time in the future. These can be useful if you have temporary income early in your retirement — such as a severance benefit or proceeds from a deferred-compensation plan — but will need the income in a few years.
The key trick to shopping deferred annuities is to keep it simple there, as well. Once you start getting past the plain vanilla promise of a fixed payout starting at a specific date in the future, different plans and providers get tough to compare — and the costs can really add up. For instance, many annuity providers will steer their deferred annuity customers toward variable annuities. Those offer the potential of higher returns while you accumulate money, followed by a guaranteed payout based on the unknown future value of your account once you annuitize.
Be careful what you’re buying
The danger to you is that once you get into the realm of variable deferred annuities, the insurance companies start to stack the deck in their favor. For instance, if they offer “stock-market-like returns,” they often have “participation rates” or other caps that limit the total percentage you can earn on the upside when the stock market does well.
The act of mixing insurance and investments in an annuity may sound good on the surface, but the costs and fine print quickly add up to make them less useful for you. If you want to invest, then invest. If you want a guaranteed fixed income for life, consider an annuity. It’s when you try to combine the two together that you most often find yourself paying more than you should for less total benefits than you otherwise could have gotten on your own.
CNNMoney (New York) First published May 15, 2018: 10:00 AM ET