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4 Questions to Ask Before Buying an Annuity

If you’ve started to research ways to generate income in retirement, you’ve likely encountered some conflicting opinions about annuities. Some see them as a welcome security blanket, while others rail against their complexity and fees. The truth is, certain types can be beneficial for turning some of your savings into guaranteed retirement income—if you know how to avoid their pitfalls.

Here are four questions you can ask to understand the differences between various annuities and help you decide whether any of them make sense for your portfolio.

1. What kind of annuity is it?

Annuities are contracts with an insurance company that seek to help you guard against the perils of outliving your assets, but the similarities often end there. That said, the types most often used for retirement income generally fall into two camps: payout (aka “income”) annuities, and annuities with optional living benefits.

Payout annuities

With payout annuities, you give a lump sum to an insurance company, and in exchange you receive a monthly payment, either for a fixed period or for the rest of your life. Importantly, that lump sum is irrevocable—once you turn it over you, can’t get it back. On the flip side, these annuities are relatively straightforward and inexpensive, and can work well with a portfolio. There are two kinds:

  • Single premium immediate annuities. Soon after you buy them, these annuities can begin paying you a consistent amount each month, typically for life, regardless of future interest rates or market performance.
  • Deferred income annuities. With these annuities, you choose a point in the future when you want the payments to start; other than that, they operate like immediate annuities. Generally, the most efficient approach is to purchase it at age 65 and start taking income around age 85 (the longer time horizon increases the income potential). That said, you should take your life expectancy into account before implementing this or any strategy.

Keep in mind that regardless of which type of annuity you choose, the annuity guarantees are subject to the financial strength and claims-paying ability of the issuing insurance company.

Annuities with optional living benefits

Some tax-deferred retirement savings vehicles incorporate investments into your insurance contract to give you the opportunity to participate in any potential market growth. Here again, there are two types:

  • Fixed indexed annuities (FIAs) track an index like an index mutual fund, but unlike a direct investment in a mutual fund, your profit is capped at a certain level. One downside of FIAs is that you can underperform more conservative investments such as certificates of deposit (CDs) during years with poor market performance.
  • Variable annuities allow you to invest in sub-accounts, which are similar to mutual funds in that they aggregate multiple investments. Given the market exposure, it is possible to lose money without built in protections.

Both types are generally complex because they offer a variety of optional features, or “riders” for a fee, including guaranteed lifetime withdrawals and death benefits.

Unlike payout annuities, deferred annuities with riders don’t require that you turn over an irrevocable lump sum. But in exchange for this flexibility, the provider may impose a surrender charges—that is, early withdrawal fees—or reduce income benefits if you withdraw more than a certain amount each year.

And speaking of withdrawals, they’ll be taxed as ordinary income. This means your annuity income will probably be taxed at a higher rate than you would pay on long-term capital gains, qualified dividends, or interest payments on municipal bonds—the kinds of income you may have if you invested in securities directly.

2. How much will the annuity cost?

The cost of an annuity depends on which kind you’re considering. Payout annuities and basic fixed indexed annuities do not have explicit costs; variable annuities and fixed indexed annuities with living benefit riders do. The table below gives you an idea of how much those explicit costs might run you. For example, a fixed index annuity with a guaranteed lifetime rider can range from 1 percent to 3 percent of the contract value. Though the average cost of a variable annuity is 2.3%, costs can exceed 3 percent.

 

Mortality, Expense and Administration (ME&A) Fees

 

Investment Management

Living Benefit Rider

Total

SPIA

NA

NA

NA

NA

DIA

NA

NA

NA

NA

FIA

NA

NA

NA

NA

FIA+

NA

NA

.5–1.5%

.5–1.5%

VA

.3–1.5%

0–3%

NA

.3–4.5%

VA+

.3–1.5%

0–3%

.5–1.5%

.8–6%

Source: Schwab Center for Financial Research with data from Annuity.org and Beacon Research. “+” indicates the availability of a guaranteed lifetime withdrawal rider. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific insurance product.

It’s also worth noting that annuity companies generally pay commissions to the brokers who recommend them. So even though you don’t pay the commission directly, this may result in a lower payout from a payout annuity provider or higher fees and surrender charges on an annuity with optional living benefits.

3. What are the tradeoffs?

Because there’s no such thing as a free lunch, every benefit you receive from an annuity has a commensurate cost—in some cases, several. In the case of a payout annuity, to gain the benefit of guaranteed monthly payments you not only give up access to your money and potential growth, you also accept that your purchasing power will decline over time (unless you pay extra for an inflation-adjustment option).

An annuity with optional living benefits can help you avoid some of the tradeoffs associated with a payout annuity, but because of their fees, they generally won’t grow as quickly as your independent investments.

4. How will this annuity work with my other income?

Consider your potential annuity in the context of your whole financial life in retirement, and determine which purpose each income stream will serve. You’ll probably already have one form of annuity-like income—monthly payments from either Social Security or a government pension—and that might be enough to satisfy your need for stable, recurring income.

But if you’re concerned about outliving your savings and want a higher level of guaranteed income that doesn’t depend on markets, one strategy might be to allocate up to 25% of your retirement savings to a payout annuity and invest the rest in a portfolio of cash, bonds and stocks so that you keep the potential for growth. Then you can withdraw from your portfolio in a flexible, sustainable way, as needed.

Another retirement challenge you’ll want to address is longevity risk. One approach to solving for this is to purchase a deferred income annuity that only begins to pay out later in life. This requires a smaller investment, usually of 5–10% percent of your savings, and can protect against the risk of outliving your money. Here again, you’ll be able to diversify the remainder of your savings in a way that allows for liquidity, additional income, and growth potential—and feel more confident in drawing money from your portfolio sustainably early in retirement.

Regardless of the strategy you choose, it’s reasonable to use predictable and—if possible—guaranteed income sources to cover essential expenses such as food, housing, utilities, and other things you can’t do without. Then look to your portfolio to fund spending on those things that make retirement fun and rewarding. 

Decided to purchase an annuity?

Use this checklist to get the following information from the person selling the annuity before you buy:

  • How are you compensated?
  • Do you offer other options for retirement income?
  • What is the insurance company’s financial strength rating?
  • What happens to my money when I die?

 

Compare Schwab’s annuity products >

Not sure an annuity is quite right?

There are other ways to manage retirement income that leverage your entire portfolio and provide similar or complementary benefits:

  • Automated portfolios offer predictable withdrawals and let you keep control of your money.
  • Other retirement income options add personal advice and guidance. 

 

Compare Schwab’s retirement income solutions >

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets

Charles Schwab & Co., Inc., a licensed insurance agency, distributes certain life insurance and annuity contracts that are issued by nonaffiliated insurance companies. Not all products are available in all states.

Unlike a CD, which is an FDIC-insured bank product, an annuity's guarantees of principal and interest are only as strong as the financial strength and claims-paying ability of the issuing insurance company. Consult an insurance company's ratings for its financial strength, and read its contract before investing.

Please note that annuity withdrawals are taxed as current income, not capital gains. This may or may not be beneficial, depending on your tax bracket. Please consult a tax or accounting professional. Withdrawals are subject to ordinary income tax and prior to age 59 1/2 may be subject to a 10% federal tax penalty.

The Guaranteed Lifetime Withdrawal Benefit is an optional rider available for an additional charge against the income base. It is not a contract value, cannot be accessed like a cash value, and will not preserve your account value which will deplete with each withdrawal until it reaches zero, though payments under the terms of the rider will still continue for life. In the absence of an enhanced death benefit, there will be no funds available for your beneficiaries if withdrawals taken prior to your death exceed the actual account value. The GLWB generally must be elected at the time of purchase and cannot be changed later. Upon electing the rider, you may be limited to a pre-specified selection of investment options. Withdrawals in excess of the specified annual payout amount may permanently reduce the income base.

The account value of a variable annuity may be more or less than the premiums paid and it is possible to lose money. Variable annuities offer tax deferral on potential growth; however, withdrawals prior to age 59½ may be subject to a 10% Federal tax penalty in addition to applicable income taxes. Variable annuities are subject to a number of fees including mortality and risk expense charges, administrative fees, premium taxes, investment management fees, and charges for additional optional features. 

Investing involves risk including loss of principal.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and bond investments, when sold, may be worth more or less than original cost. Fixed income securities are subject to various other risks, including changes in interest rates and credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.   High-yield bonds and lower-rated securities are subject to greater credit risk, default risk and liquidity risk.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

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