Is An Income For Life Annuity Too Good To Be True?

by Neal Frankle, CFP ®

An income for life annuity sounds pretty swanky – right? Who wouldn’t want perpetual income? Well…as you’ll see, an income annuity might be good for some people but it isn’t a good fit for others.

What is an Income Annuity?

An income annuity is a contract between an investor and a Life Insurance Company. In exchange for a lump sum payment paid for by the investor, the Life Insurance Company assures monthly payments during the duration of the contract. In the case of a fixed annuity, the monthly payment is ongoing until the investor’s death. For example, if the investor buys the annuity at the age of 60 and dies at 95, he will benefit from a secure payment for 35 years. On the other hand, if the investor dies the day after he signs the contract his heirs are out of luck. They won’t get a dime. (There are some annuities that continue making payments even after the owner dies. Those are called “term certain” annuities.)

Even though Neal can’t stand annuities, even he would admit that they do have their benefits. You avoid market volatility risk as your payment is 100% guaranteed by the issuing company. And the value of the contract could be entirely or partially guaranteed by the Government in the case where Life Insurance Company defaults. Let’s keep going.

Guaranteed Life Time Payments…. Where’s the Catch?

As you probably know, there are no free lunches in finance. Annuities are complex financial products and they exist in various forms. Some work for investors and I’ll get into that in further detail. But some of them only exist in order to make big profits for insurance companies and pay high commissions to the broker. And annuity owners have to especially cautious right now. Keep in mind that the income you receive is based on current interest rates. Since rates are so low, if you buy an annuity now you’ll be locked in to terribly low rates for the rest of your life. Sheesh. And there are tons of other drawbacks to annuities. I am only scratching the surface.

Who Should Consider Annuities?

With all their drawbacks there are a few cases where these investments could make sense.

#1 You are concerned about your retirement plan. Since annuity payments are 100% guaranteed, this buys you buy peace of mind throughout retirement.

#2 You are familiar with investments. If insurance jargon doesn’t tick you off and are familiar with other investment terms, buying an annuity can be easier for you as you fully understand how it works.

#3 You are looking for a stable stream of income. Annuities provide a steady stream of income during the period of a contract.

#4 You are concerned about longevity. One of the main risks at retirement is the possibility of outliving your savings. You might be able to avoid this risk with an annuity.

#5 You tend to be risk-averse moving towards your retirement years. If you do not want to invest in equities, the fixed income options are not offering interesting rates of return right now. An annuity could be an attractive alternative.

#6 You are in a high tax bracket. A part of the annuity payment is considered a return of capital. Therefore, the payment received is not fully taxable.

#7 You are pessimistic. If you don’t believe in the stock market and think that all financial advisers are only out for your money, an annuity contract will guarantee you that you will get paid. The return is usually better than the one found for certificates of deposit. Of course, that’s only because they are giving you back your principal as well as the paltry interest they pay.

#8 You are a Woman! It is well known that women’s life expectancy exceeds men’s life expectancy by a few years. Therefore, if you are a healthy woman, your annuity income could well be worth the investment.

Final Thoughts on Annuities

As you can see, this product was designed for risk adverse people who seek a stable source of income. It is true that you might make a lot more money investing in the stock market, but you could also lose. This would not happen with a fixed income annuity. Financially, the annuity doesn’t make sense for many people because it’s so expensive, you lock in low rates; you give up random access to your money and many other reasons. But as I said, for certain people, it might be a smart move despite these drawbacks.

This guest post was written by Mike, a passionate investor and personal finance enthusiast. He writes about complex financial topics to make them easy to understand. He is the author of Annuity Rates HQ.

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