Introduction
Many retirees see the value of annuities to ensure they do not outlive their nest egg by providing a guaranteed income stream along with Social Security or pensions. But annuities can be complex insurance products and should be carefully considered for your particular circumstances. Below are some common pitfalls to avoid.
Not Understanding Different Types of Annuities
Between immediate and deferred, fixed and variable, qualified and non-qualified, there are numerous annuity products on the market from hundreds of different companies. With each company offering their own nuanced take on each product. Navigating these waters typically takes a trained guide.
Not Understanding the Fees and Costs
Many people who prefer annuities over bonds typically do so because of the flexibility of annuities. There are several different types of annuities that can come with many features such as death benefit riders, guaranteed income riders, etc. But with these features come more fees and costs. Knowing exactly what you’re paying, when and for what will mitigate the chances of surprise expenses or less guaranteed income than what is expected.
Not Accounting for Inflation
As of this writing inflation has begun to cool. But in June of 2022, inflation peaked at 9.1%. That is the kind of frightening number that keeps retirees awake at night! Recent inflation has taken a big bite out of fixed retiree income. COLA to Social Security can only do so much. We obviously cannot predict the future (who saw a global pandemic coming in 2020!), but when purchasing annuities some hedge for inflation can be included. This can come in the form of variable annuities and index annuities tied to specific indexes such as the S&P 500. It should be noted that interest caps are typically included with these types of annuities. So, you will usually not be able to take full advantage of a good market, however, oftentimes there is an interest rate floor which will protect you from down markets. Of course, with this type of complexity you will see additional fees and costs. This will also need to be considered. Another potential hedge would be to ladder annuity purchases. Click here for more on that strategy. e easier access to the principle in a bond than you do for an annuity. In an annuity, “prior to maturity withdrawals are not anticipated over and above the scheduled payment amounts. This period before maturity is known as the surrender-fee period.” The longer an annuities’ surrender period, the more time it will take until you have access to your annuities’ initial principle. This may not be an issue if properly planned, but if an emergency were to come up and this annuity was your last resort, you will have to pay extra fees to gain access to the money. There are some exceptions to this, but that will need to be negotiated in the initial contract.
Not Understanding the Tax Implications
There’s a belief out there that annuities are tax free. Although it is true that annuities can grow tax deferred, taxes will come due when payouts occur. There are also different tax implications for qualified vs. non-qualified annuities. If the annuitant dies and the annuity is inherited, inheritance taxes (federal and state) may apply. For more information on annuity taxation, see this article. A qualified tax expert should be consulted when purchasing annuities.
Over-Investing in Annuities
Annuities are a sound financial choice for providing some guaranteed income. But as discussed above there are limitations to consider when including annuities as part of an overall portfolio. Over-investing in annuities can lead to over exposure to inflation or too little diversification in the overall market and so on. The risk of annuities needs to be properly balanced in a diversified portfolio.
Consulting with a qualified financial advisor can help you navigate these complexities and help avoid these common pitfalls. You can have confidence that annuities are a good option in a diversified retirement income plan.