By Kelly Robinson, Spring 2016 Student Intern
When assessing any financial product, the investor should balance its benefits against potential drawbacks. This can be a difficult task for the casual investor, as it can require the investor to have an elevated understanding of other financial products and processes. This is especially true for more complex products, like annuities. Today, we will be exploring an annuity’s general benefits and drawbacks, as well as some of the underlying concepts related to each.
With annuities, this risk is prevalent in several different areas, the first of which is their surrender period. If you have every carried a certificate of deposit (explained further by Investor.gov), then you are likely familiar with the concept of a surrender period. This is a fixed amount of time in which the insurance company holds your money. This is typically defined in yearly terms of anywhere from 2-10 years (compare this to a certificate of deposit, which normally defines the surrender period in months). If you try to withdraw money from your annuity before this period has passed, you will incur a surrender charge. These charges can be quite high at the start of the period (10%), but some will decrease over the course of the surrender period.
There can also be substantial charges, fees, and commission associated with annuities. Extra charges can come in the form of surrender charges as mentioned above, as well as in additions to the annuity such as riders. Riders “ride along” with the product and add to the product while also adding costs. Some common riders include death benefit and cost of living riders which can increase the payout rate or payment amount based on terminal illness of the holder or due to inflation, respectively. Typically, there are also annual fees. These can come in the form of management and administration fees, rider fees, and mortality and expense risk fees. These can add up to 2-3% to the cost of the annuity annually! Commissions can potentially increase the cost of the annuity up to 10% of the value.
For retirees, or those close to retirement, annuities can reduce longevity risk. Longevity risk, in this sense, is the risk that one will outlive their retirement savings. This is a very real concern as people are living well beyond retirement and may not be receiving a meaningful stream of income from a pension. The purchaser cannot outlive their pension payments and in some cases, you can name a beneficiary so that when you die the beneficiary receives the payouts (for an extra fee, of course).
Another possible benefit of an annuity is the ability to offer tax-deferred growth. While earnings are taxed at the regular income tax rate, the amount of money you contribute to the account is not taxed, increasing the amount compounded each year. Additionally, there is no limit to annual contributions as there are with plans such as 401(k)s. This can be especially useful if one is nearing retirement and has not contributed as much as they may have liked.
The Bottom Line
The main things to remember when assessing an annuity are your liquid cash needs, your time until retirement, and the associated costs, fees, and commissions of the annuity. Don’t let a pushy broker talk you into an annuity without doing your homework, you could be locking yourself out of your money while also paying for their extravagant vacation. For a great quick guide to annuities, check out the SEC’s Fast Answer section.