For some, annuities play an important part of the retirement planning process. These products may be a useful addition to other savings. What are the advantages and disadvantages of using an annuity to build retirement income?
What is an Annuity?
An annuity is a financial product offered by insurance companies. In return for invested cash annuities will pay out a lump sum or income at specified intervals (usually once the investor has retired). The cash that is paid out is based on the original investment and the interest it has accrued over time.
What are the Differences Between Fixed and Variable Annuities?
There are basically three primary types of annuity: fixed, variable and equity-indexed. The product type that is chosen has a bearing on the payments made. For example:
- A fixed annuity will pay out a set amount to a schedule that is agreed when the contract is set up.
- A variable annuity is based on investment performance so no guarantees of payment amounts are given.
- An equity-linked annuity offers elements from both fixed and variable products and set payments.
Before investing in an annuity individuals may want to look at the pros and cons.
What are the Advantages of Using an Annuity to Save for Retirement?
There are various advantages to annuity investment. These products can, for example, give the following benefits:
- Income guarantees: Annuities can give a guaranteed income. A fixed annuity, for example, will give a secure income for the contracted period.
- Payment flexibility: Annuities can be purchased with a lump sum payment, regular payments or periodic payments. This allows individuals to use them at various life stages. Some will buy early in life; others will buy just before retirement.
- Annual contributions: There are no pre-set annual contribution limits for annuities.
- Payout flexibility: An annuity can be set up to make a one-off payment or regular payments (i.e. monthly or annually) for a number of years or for life.
- Tax status: Any profit made on an annuity will be tax-deferred until it is paid out. In some cases tax will only be applied to interest earned and not to the principal investment.
- Death benefits: If the investor dies before the annuity pays out then their next of kin will usually receive at least what they have paid in. In some cases, if they have a pre-determined payment schedule, they may also receive the income.
For many, the primary advantage to using annuities is the fact that they can be used for guaranteed income that does not have to be dependent on stock market returns.
What are the Disadvantages of Buying Annuities as Retirement Income?
Choosing whether an annuity is a suitable retirement investment tool also involves looking at the disadvantages. These include:
- Tax status: At least part of annuity payments may be liable for taxation. In some cases (i.e. a lump sum payment) the entire annuity payout may be taxed. Tax rates are set at income tax levels which are higher than the dividend rates charged for other investments such as mutual funds.
- Age limits: An annuity cannot pay out until the investor reaches the age of 59½ without penalties. Closing down an account inside a specific timescale can incur additional early settlement fees and costs.
- Cost: Annuities may be one the most expensive retirement savings options and come with a variety of fees and charges.
- Inflation: The set payout that is given may look good when buying the annuity but the effects of inflation over the years could reduce the real value of the payout when it happens.
- Lack of flexibility: Annuities offer fixed benefits and once a contract has been signed it may not be able to be changed. If changes can be made, there are likely to be costs involved.
- Death: Although an annuity will pay back payments made or continue paying out (depending on the product stage) those inheriting this cash will have to pay income tax on it.
Those unsure about whether annuities are right for their needs may find it useful to talk to an independent financial advisor to discuss their options in more detail.
Things to Consider Before Buying an Annuity
Annuities can play a useful part in retirement planning for some. Those looking for a guaranteed income, for example, might use these products to form their base income and use savings with less predictable returns as an add-on. Higher earners and those that have maxed out their allowances in other products may also find these products useful due to their tax deferred status. Understanding how an annuity works is an important part of the decision making process.
Those close to retirement may also find a last-minute immediate annuity useful to top up savings. Longevity insurance may also work for those that worry that they may outlive their savings. Taking some time first to assess whether enough has been saved for retirement and how much needs to be budgeted for may be useful.
Carol Finch - Carol Finch is the Topic Editor for Retirement Planning, Budgeting, E-Commerce & Technical/Business Writing on Suite101.
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