For any investment, a determination must be made as to its suitability, and ultimately, it potential to meet an individual’s investment objective within the bounds of his or her tolerance for risk. The most fundamental rule of investing is that no one investment is right for everybody, and that it is the financial profile of an individual which determines whether any one investment is suitable or not. Annuities are certainly not for everybody, and if an individual’s needs, priorities, investment objectives or risk tolerance is not carefully considered, they could turn out to be a bad investment. For the right person, annuities can be an extremely good investment.
Good or Bad Depends on the Individual’s Financial Profile
Annuities are designed as a long term investment with special features that can benefit investors who seek tax advantages, preservation of principal, security, predictability and certain guarantees. While some annuities, such as variable annuities, do offer the potential for higher returns, investors who don’t have these objectives or concerns may be better off investing in mutual funds. A breakdown of the key features of annuities is one way to determine if they would be a good or bad investment.
Deferred Taxation of Earnings
The taxation of earnings inside of annuities are treated the same as qualified retirement plans in that they are not taxed currently. They are allowed to accumulate without taxation until the time they are received. While this can be tremendous advantage for people in higher income brackets, it would not benefit people in lower tax brackets. The people in higher tax brackets also have to be willing to wait until after the age of 59 ½ to withdraw their funds in order to avoid a 10% IRS penalty. Annuities can be converted to income (annuitized) at any age which would not trigger the penalty.
Fixed Annuity Rates
The rates on fixed annuities are competitive with any taxable equivalent vehicle. In fact, annuity rates tend to be slightly higher than term deposits such as bank CDs. In many annuity products, the rate is guaranteed for a certain period of time, after which, it is adjusted based on the prevailing rates at the time. So, it is possible that, the new rate will be lower than the initial rate; however, most annuities include a “bail-out” provision which allows investors to transfer their money to another annuity without incurring taxes, fees, or a penalty.
For investors who seek safety and stability for at least a portion of their investment portfolios, annuities are a great investment, and the fact that their rates are competitive means that investors don’t have to sacrifice returns for greater safety. If you believe that interest rates will increase in the future, then fixed annuities can be a good investment. For investors who are more risk oriented or concerned about the possibility that future interest rates could drop substantially, annuities could turn out to be a bad investment.
Annuities do provide their investors with some access to their funds. Investors can access their accumulation account to the extent that the annual withdrawal does not exceed 10% of the balance. Should they need to withdraw more than 10% in a year, they will incur a surrender fee which could range from 5% to 12% in the first year. Each year, the surrender fee is reduced by a point, so eventually investors would have complete access to their funds (but could still incur a 10% IRS penalty if younger than 59 ½).
For investors with a long term time horizon and sufficient liquidity among other assets, annuities are good investments over a long period of time. Investors, who haven’t accumulated sufficient liquid savings or alternative assets, may find annuities to be bad investments if they find should find themselves in need of funds in the short term.
While annuities are popular accumulation vehicles, their original purpose was to secure a person’s future income so that it could not be outlived. Today, annuities still provide the best solution for people whose primary concern is capital preservation and a secure lifetime income. For investors who lie awake at night wondering if their income sources will last their lifetime, fixed annuities may be the best solution. They must be secure in the knowledge that the capital they apply to the annuity is inaccessible as it must be committed to the life insurer so that it can guarantee the lifetime payments.
For investors who are concerned with giving up complete control of their asset to a life insurer, annuities would not be a good investment. If, however, they controlled other assets that were also producing income, and were available in case of an emergency or short term need, then an income annuity could provide the income safety net which would make them feel much more secure.
As with any investment, annuities must be considered in the context of a person’s own financial objectives, preferences, priorities and risk tolerance. When a person’s financial profile is a match for the features and benefits of annuities, it can be a great investment choice, especially when it is a part of an overall investment strategy consisting of a diversified and balanced portfolio.