When you make any investment decision, you balance between expected risk and potential reward. Time complicates this question; when can you expect to get your payoff? For example, if you won $100 million in the Powerball lottery, would you prefer to get $50,000 a month for the rest of your life or a $48 million lump sum right now?
(An economist would likely choose the lump sum over an annuity lottery payment, because the time value of that money is better than the fixed payment every month, especially if the monthly payments are non-transferable.)
What is an Annuity?
A very conservative investor may want to put his or her money in an investment vehicle which has guaranteed regular payments at an agreed-upon rate. An annuity is a contract with an insurance company where you make a fixed payment now and receive future payouts. In other words, they get the money now and you'll start getting (smaller) checks in the future.
A deferred annuity is an investment where you pay money during a savings phase and receive money during a payment phase. If this sounds like a 401(k), you're right—it resembles a retirement account. (It's not the same as a 401(k), however, but you can invest in a deferred annuity as part of a 401(k).)
An immediate annuity is an investment where you pay a single lump sum now and immediately start receiving disbursements. The larger the lump sum, the greater the monthly payment. (This resembles the lottery winning example, where you don't take the lump sum.)
Types of Annuities
Annuities differ on how they pay out their disbursements. A fixed annuity pays out a specified rate of return which never changes for the life of the annuity. This is generally a very low rate of return. Think of it like a CD (especially as CD interest rates are currently terrible.)
An indexed annuity ties its payments to the returns of a market index, such as the S&P 500 index. The principal you've invested stays guaranteed, and the return you get reflects the growth of the underlying investment.
A variable annuity invests your principal in one or more underlying securities. This offers better potential for growth than a fixed annuity (no potential for growth), but it has the risk (potentially losing your entire investment).
What is a Structured Settlement Annuity?
One special case of annuity is worth calling out explicitly. If you've received a judgment in your favor in a lawsuit, you may receive a large settlement reward. If this is the case, look into setting up a structured settlement. A structured settlement annuity is an investment specifically structure designed to replace lost wages or to pay for medical treatments. It's generally tax free. This isn't generally a retirement investment; these vehicles exist to ensure a stream of income to make up for damages suffered from a third party.
Yet it's an investment which pays out from a principal. As you might expect, there's an entire industry dedicated to setting up these financial instruments and plenty of money devoted to helping you cash out or to buy out a structured settlement annuity.
Should you sell a settlement annuity? If you find yourself in this situation, be careful. Your best option is to find a trusted fee-only financial advisor to review your situation and recommend the best way to proceed. Don't succumb to immediate pressure to sell your annuity, as this is a complicated process and it's too easy to get forced into cashing out at a huge discount.
Are Annuities Good Investments?
Annuities can be good investments for extremely conservative investors who want a guaranteed income stream and are willing to put up a large chunk of liquid cash to ensure that.
If you prefer predictability over all else—including the potential for growth, tax concerns, or beating inflation—then an annuity may make sense for you. In other words, if your investment philosophy is "avoid risk at almost any cost", an annuity is a good option.
Why not Buy an Annuity?
Annuities aren't often good investments. Their fees can be high (certainly higher than an index fund. Furthermore, though a fixed annuity preserves your principal and guarantees a return, that return in real dollars will not change throughout the lifetime of the annuity. In other words, inflation will slowly chip away at the value of the annuity. $1000 in 1985 was worth more than $1000 in 2015. Sorry, Back to the Future fans.
Worse, annuity disbursements tend to be taxed at income tax rates, while securities invested for over a year are subject to capital gains tax rates. These tax rates are currently a lot lower than income tax rates.
Finally, should you sell an annuity, you may face huge penalties (and have structural difficulty doing so). The cash out process can be difficult and troublesome.
Guaranteed Income for Retirement Planning
Are there better alternatives to annuities? That depends on your financial goals. Many investors prefer a laddered approach: some semi-liquid money easily accessible in CDs, more money invested in tax-free municipal bonds, and the bulk of the portfolio in index funds and value investing possibilities. It's a little more work to manage all of these instruments, but it is a nice mixture of safety, growth, and control—and it's rarely subject to tax penalties or inflated money management fees. That's a nice way to build wealth.
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