Should I Buy an Annuity?

Annuities have been providing financial security for people for a millennium. As a financial instrument there is none older, and as savings vehicle there are few that more misunderstood. Still, people who are beginning to get serious about their retirement savings are turning to them in record numbers. Because, what many people do understand about annuities it that the can be a source of financial security unlike any other investment. But, clearly, they aren’t for everyone. To truly answer the question, “Should I buy an annuity?” you would have to first seriously consider your own financial situation to determine if it is the right solution for you.

Annuities are more than just financial products. They are financial solutions that fill a need or address a concern, whether it is for tax savings, guaranteed income for life, portfolio stability, guaranteed growth, or simply some peace-of-mind. But, they are also somewhat complex, which is, perhaps, why some people shy away from them. But once you more clearly understand your own needs, priorities and tolerance for risk, it is much easier to consider annuities as a solution, and as a way to fill a need or address a concern. And, that’s the only reason why you should buy an annuity.

What are Your Needs and Concerns

I am concerned about outliving my income: That’s not an uncommon concern. Recent studies reveal that the majority of the American public is extremely anxious about having enough money to last their lifetime. Annuities today offer the same promise as they did to Roman citizens 2000 years ago, and that is that the income generated from a cash deposit, is guaranteed to last as long as you do, regardless of how long you live. Your annuity contract with a life insurance company becomes an obligation, backed by the assets of the company, to make monthly payments based on a cash deposit and your life expectancy. If, as more and more people do, you live beyond your life expectancy, the company is still obligated to make the payments.

I’m concerned about keeping up with inflation in retirement:

This is a concern that many people haven’t really considered. The fact is that, if you do live for 20 or more years in retirement, your cost-of-living will likely double based on the current rate of inflation. It’s one thing to have enough income to last a lifetime, but, if it can’t keep up with your actual expenses, it can make life pretty difficult. Many people are relying up their retirement funds to keep growing in their retirement accounts. In order, for their income to increase over time, their retirement funds will have to be invested in growth investments which are risky.

Most annuities include an option that ties your income to an inflation index so it will automatically increase. Variable annuities offer an option that enables your income to increase in rising equity and bond markets, while protecting it from declines. While these options do cost extra, they can turn out to be priceless when the economy goes sour again.

Annuities Explained

I’m concerned with the safety of my principal:

As are millions of people who lost significant sums of money in the recent market crash. Even the people with money in the bank lost some sleep when hundreds of banks were closed during the financial crisis. Fewer people are feeling secure about the Federal Deposit Insurance Corporation (FDIC) which could actually run out of funds if too many banks fail at once. Annuities have always been considered among the safest of all savings vehicles. During the Great Depression when customers of failed banks were receiving cents on the dollar, life insurance companies were making their annuity customers whole.

Unlike banks, which are required to maintain a small fraction of reserves on hand to cover immediate obligations, life insurance companies are required to have nearly 100% of reserves on hand in the form of safe, liquid assets. Sure there have been a few life insurance companies that became insolvent, but the states ensure that their reserve requirements will be met by other life insurance companies. Annuities are sleep insurance. For an even better sleep, try to work with companies that have the highest ratings for safety and stability. There are plenty of annuities to choose from among the top 20 life insurers.

I’m concerned about paying too much in taxes from my savings and earnings:

Although tax rates have come down quite a bit in the last few decades, people are still heavily taxed, especially when you combine federal taxes with state and local taxes. The effective tax rate for many people can still reach as high as 50%. When that happens, 50 cents of every dollar of interest earned is lost, forever, to taxes. By keeping that 50 cents working in your investment account, compounding over many years, you can more than double your accumulation, and that will make a huge difference for people who are concerned with accumulating enough for a secure retirement.

Annuities are one of the very few individual financial instruments that allow your funds to accumulate without having to pay taxes on them. Your funds will eventually be taxed as ordinary income when they are withdrawn, however, for most people, the tax rate in retirement will be lower than during their working years. It is important to be aware of the penalty for withdrawing funds too early (prior to age 59 ½), however, if you are saving for retirement that may not be a concern.
I’m concerned with the low yields that my money is earning right now:

Current interest rates are still at historic lows. While that may be an advantage if you’re borrowing money, it makes accumulating money very difficult. Fixed annuities do offer yields that are higher than other safe savings vehicles, such as CDSs; however, if you want your money to work harder without much additional risk, then you could consider an indexed annuity or a variable annuity with optional guarantees. With an indexed annuity, your yield is linked to a stock market index, so if the market rises, your yield can rise. Although there is an upper cap on the yield (in the range of 5% to 8%), there is also a minimum rate guarantee, so, even if the market index declines, you will still earn a positive return. The funds in variable annuities are invested in stock and bond accounts, so there is market risk involved; however, many variable annuities offer an option that will guarantee a minimum rate or a minimum withdrawal amount based on your principal. These options do cost extra but they enable you to enjoy the upside without concern for the downside.

There’s much more to annuities that you will need to know – there are expenses, withdrawal provisions, different savings options, as well as the fact that there are hundreds from which to choose. However, your most important consideration in determining why you should buy one is how it will help you address your needs and concerns. If you share one or more of the concerns listed here, an annuity may be right for you.