Annuities are contracts between individuals and life insurance companies that allow the individual to convert a lump sum of money into a lifetime of monthly payments. An immediate annuity allows you to convert a lump sum into monthly payments. Alternatively, a deferred annuity allows you to accrue assets through monthly premiums and upon reaching retirement age, convert that money into a lifetime stream of monthly payments. Annuities can be a solid part of any retirement strategy. However, there are a number of pros and cons associated with annuities that you should be aware of when considering purchasing one.
Pro: Lifetime Payments
You get a fixed rate of return for a preset number of years. Knowing you will receive a certain amount of money each month can help you plan for any necessary lifestyle adjustments. Beyond this, annuity contracts also offer a certain peace of mind that comes with the security of knowing you will receive money each month.
Pro: Asset Accumulation
Annuities allow you to accumulate a considerable amount of assets through investments such as debt, equity, real estate and money market mutual funds. Part or all of these assets can be withdrawn before retirement age in the event of financial hardship (though there will likely be tax consequences). These funds can also be borrowed according to the stipulations of the annuity contract. Upon death, your beneficiary or heirs may receive the remainder of the assets according to the stipulations of your contract or will.
Pro: State Funding Guarantee
Most states have funding in place that will cover insurance claims, at least in part, in case your life insurance firm goes bankrupt or is otherwise unable to pay your claim.
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Con: Threat of Inflation
The purchasing power of your annuity payments might diminish if the country experiences a period of extreme inflation or if you acquire a large unanticipated expense, such as an emergency medical procedure not covered by insurance.
Con: Hidden Fees
Annuity contracts often come loaded with a number of management fees that can eat away at the assets you accumulate. These fees are often hidden in a maze of jargon, but they can significantly affect your payout. Furthermore, if you are in need of cash from your annuity for an emergency relatively early into your contract, you might not have accumulated sufficient assets to satisfy it because fees are eating up your premiums.
Con: Outliving Your Payments
Some annuity contracts are tied to the value of the assets you have accumulated in your account. You might receive a variable rate based on life expectancy that could leave you short of cash during a particular period if the capital markets take a major hit. Or you might have to accept a low monthly payment rate--one on which you cannot afford to live--in order to ensure lifetime payments.
Before Purchasing an Annuity...
Enlist a certified financial planner, rather than an insurance agent, to help you review the contract. Insurance agents are often more interested in selling you the annuity--from which they are paid a commission--than ensuring that a particular annuity is the best option for you. Make sure you are clear on all fees and factors that can affect your payout before you sign.