What to know before you buy an annuity

Annuities are something your grandfather warned you about, but what if an annuity is right for you? Here’s how to know if you should buy an annuity. To talk with someone about how an annuity might help you, contact our friends at Gainbridge here.

How to know if you should buy an annuity:

What’s an annuity?

The short answer is that an annuity is an insurance contract that gives the holder or annuitant (and their spouse if a survivor benefit is selected) guaranteed income for life.

The long answer is that an annuity is an insurance contract – not an investment – issued by a financial services firm or insurance company. It pays out invested funds, often earned interest and sometimes growth, in a fixed income stream sometime in the future. Many people buy annuities to give them guaranteed income for a pre-determined duration, usually for life.

Therein lies the main benefit of annuities; annuities help reduce and even eliminate income insecurity for those who need it, usually retirees.

Think of a trapeze artist in training with a safety net below them when they practice. They’re skilled, but they have a net below them for extra protection. Annuities are like that safety net and can be tools that protect you from outliving your income, a fear many older LGBTQ people live with today. This concern for LGBTQ folks was highlighted by a MassMutual study.

Annuities, though, are long-term strategies, not short-term strategies and they can be a part of a long-term financial plan, not necessarily the whole financial plan.

What types of annuities are there?

There are different types of annuities, immediate and deferred, fixed and variable and, of course, hybrids. There are always hybrids.

Immediate annuities are funded with lump-sum payments from an inheritance, lawsuit settlement or lottery winnings in exchange for immediate cash flow that lasts for a pre-determined term or a lifetime. Deferred annuities are usually for older investors looking for tax-deferred growth and guaranteed income by a certain date in the future and to last for a pre-determined duration or a lifetime.

Fixed annuities are just that, annuities with fixed terms such as fixed interest rates and fixed payout periods. Variable annuities offer payouts of variable sizes based on the performance of an underlying portfolio of investments designed by the insurance company and payouts are contingent on contributions during accumulation, rate of return and fees.

Indexed annuities are a hybrid of fixed and variable annuities and are the more complex kind of annuities. Indexed annuities offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. An underlying index, for example, would be the S&P 500. An annuity indexed to the S&P 500 won’t mirror the S&P 500 but be affected by it.

What are the phases of annuities?

There are two phases of an annuity, the accumulation phase and the payout phase.

During the accumulation phase, the annuitant makes payments that may be split among various investment options. This payment could be a lump sum payment or recurring payments or contributions over time

During the payout phase, the annuitant gets payments back, from principle, income and possible gains. The payout phase can last for a pre-determined duration, such as 15, 20 or 30 years, or for the life of the annuitant (or their spouse if a survivor benefit is elected).

What are the risks with buying variable and indexed annuities?

Variable and fixed annuities are designed for holding for the long term. They also carry the risk of market fluctuation because of the underlying index, though losses can be mitigated with the right annuity rider. Finally, there are often early payout fees and taxes due upon early payout.

What’s an annuity rider?

Ads for cars often display the base-model price. Car buyers then add features to their car orders that increase the net cost. Car buyers can add as many features as they want and the more features, they add the more their cost increases.

Such is the case with annuities and annuity riders. Annuitants can pick a “base model” fixed, variable, immediate or deferred annuity, then add riders or additional features to accommodate needs or concerns they have.

Two common riders include a living benefit rider and a death benefit rider. A living benefit rider helps annuitants while they’re alive, payouts track inflation and are based on the annuitant’s or the annuitant’s spouse’s age. A death benefit rider triggers when an annuitant has passed away and the money from their annuity goes to a beneficiary, to pay for funeral expenses or funds a donation or charity.

Other riders can include maximum loss protections for indexed annuities, as alluded to above, accelerated payout benefits due to a terminal illness, a cost-of-living rider pegged to inflation or the Consumer Price Index (CPI). There are also impaired risks, commuted payouts and long-term care riders.

How much do annuities cost?

Fees for an annuity can include but aren’t limited to:

• Administration fees
• Early withdrawal fee
• Add-on riders
• Agent fees

As explained in the car analogy, the more complex an annuity contract the more expensive the annuity.

An agent who sells the annuity is paid either one of two ways, a commission or a flat fee. Commissions are paid based on the dollar amount put into an annuity contract. A fee is paid out based on the features added to the annuity contract and can range between 0 to 10%.

For example, when you get a bottle of wine at a restaurant the cost of the bottle of wine and how much you spend will increase based on how much you decide to tip (like a commission). If you go to a liquor store, the only way your cost will increase is based on how many bottles of wine you get (like the riders you buy).

When should you consider buying an annuity?

The primary reason most folks buy an annuity is that they want guaranteed, predictable income. So, the main reason you might consider buying an annuity is that you are at a point in life where you want guaranteed, predictable income.

An annuity also offers an unlimited tax-deferral opportunity. Both company-sponsored retirement plans, such as 401(k)s, and Individual Retirement Accounts (IRAs) have contributions limits and are only available to those who have earned income each year. So, if you’ve either maxed out these two retirement plan options or you’re not currently working and still want to save money in a tax-deferred vehicle, an annuity is right for you. An added bonus is that there are no withdrawal requirements; you can hold your annuity as long as you like.

Other reasons to consider buying an annuity are that the stock market’s too volatile for your risk tolerance and you want premium protection, you want a more certain return or you want to know exactly how much interest you’ll earn. Finally, annuities can offset any inability to get life insurance or give you long-term care protection if you don’t want to pay for it out of pocket.

What are the risks of buying an annuity?

As with everything, annuities aren’t without risk. Below are some risks to consider before you buy an annuity.

1. Opportunity cost

Opportunity cost is the loss of potential growth you might get by putting your money elsewhere, likely in the stock market.

It’s important to remember here that an annuity is not an investment and annuitants aren’t necessarily looking for growth. Plus, opportunity costs are only truly applicable to those with higher risk tolerances. Conservative investors or those who would otherwise prefer sitting in cash aren’t truly affected by this risk if they’re able to sleep better at night.

2. Purchasing power risk

Purchasing power risk is an inherent risk with annuities because the yield that an annuity generates may not keep up with inflation, thereby making it harder to buy as much or more tomorrow as it is today. Purchasing power risk is also a risk for those who keep their money in cash, interest-bearing accounts and low-yield money market mutual funds and yet many people still put their money in these investments.

3. Liquidity risk

Liquidity risk is the risk of not being able to easily access the money in your annuity, which is also inherent in many fixed income products and alternative assets including real estate.

Many annuity issuers, though, let annuitants withdraw up to a certain percentage of their cash each year without penalty. This premature withdrawal is usually capped at 10%. Money that’s withdrawn prematurely from an annuity, however, might still be taxed.

4. Surrender risk

Surrender risk is the risk of having to pay surrender fees on money prematurely withdrawn from an annuity. Surrender risk includes both early withdrawal fees (possibly waived for withdrawals up to 10%) and taxes.

5. Market risk

Similar to investing in stocks, mutual funds and ETFs, market or investment risk is the liability inherent with variable and indexed annuities, as a portion of the annuity mirrors all or a part of the stock market. Market or investment risk can be mitigated by protective riders that transfer down market risks to the issuer.

6. Credit risk

Credit risk, same as with bonds and other fixed-income products, is the danger the annuity issuer will go insolvent making it impossible for the issuer to make the agreed-upon payments to annuitants. If you’re considering buying an annuity, review the creditworthiness of the issuer with rating agencies such as AM Best, Standard & Poor’s, Moody’s and Fitch, and only buy highly rated annuities.

We’ll start and end this section by saying that annuities aren’t without risk. That said, nothing is without risk. The stock market isn’t without risk. Keeping your money in all cash isn’t without risk.

What each of us needs to do is educate ourselves on all the risks of all the tools that we consider as part of our overall financial plan, then balance the risks that we can tolerate with the rewards we seek.

Why do people buy annuities?

The main reason people buy an annuity is that they either want periodic payments for a specific duration or guaranteed income starting on a certain date and for the rest of their lives. Ideally, this annuity income complements incomes received from Social Security, retirement account investments and other income streams but can, in some cases, be a solution if other sources of income are insufficient.

Another popular reason folks buy annuities is the tax-deferred growth. This is a key benefit for people who have already maxed out contributions or don’t have access to other retirement vehicles. Tax-deferred growth is an efficient way to grow retirement assets because taxes on annuity interest aren’t due until the money’s withdrawn. This lets annuitants benefit more over time from compounding interest.

Finally, many annuity holders purchase their annuity for death benefits. That means you can leave money to your heirs whether you want to leave behind a legacy or to take care of your loved ones after you’ve passed. Money left to beneficiaries on an annuity often doesn’t go through probate and beneficiaries can receive either the entire account value, principle minus withdrawals or the account value plus accrued interest through a guaranteed death benefit.

What are the myths about annuities?

There are many myths about annuities and those myths often repel people from considering purchasing an annuity even if it would be a great solution for them. It’s important to separate fact from fiction so you can make the best decisions for yourself.

1. Annuities are bad investments

As we said on Queer Money® episode #298, annuities aren’t investments; they’re insurance contracts. So, comparing annuities to stocks and stock market performance is like comparing apples to oranges.

Annuities are just another tool to possibly augment your overall retirement plan and, ideally, no more. Remember, except for Social Security (which many people think won’t last) and pensions (which many people don’t have), annuities are the only product that can guarantee a stream of income that you can’t outlive.

2. Annuities are risky

Let’s be real. There’s no 100% riskless path to retirement security. There are inherent risks with investing in the stock market. There are risks to not investing in the stock market. Even CDs and bonds have inherent, though different, risks. Annuities are simply one tool in a toolbox of tools to improve your financial security in retirement and it’s one of only a few tools with which to generate income for life.

That said, it’s possible to mitigate the risks of purchasing an annuity. Annuities are backed by the full faith and credit of the insurance company. So, you’ll want to pick an insurance company with a good credit rating by either Standard & Poor or Moody.

“If you're looking for some way to get more yield and don't want to go all the way to a stock or even maybe a step towards a bond, an annuity is definitely an option.” - Sean Cox Click To Tweet

This might sound convoluted, but insurance companies purchase insurance from other insurance companies. This helps reduce the insurance company’s risks and ensures that one insurance company doesn’t carry more risk than it can withstand if something cataclysmic happened. Insurance purchased by other insurance companies is called ‘reinsurance.’ So, you’ll also want to make sure the insurance company you pick has reinsurance for your added protection.

Finally, it might be helpful to know that every state covers a minimum of $250,000 in the present value of annuity benefits, including net cash surrender and net cash withdrawal values

3. If I have an IRA, I don’t need an annuity

Annuities offer tax-deferred growth, the same as retirement accounts. So, a common objection to buying an annuity is that it’s a waste of time to even consider getting an annuity unless an investor is already maxing out contributions to both company-sponsored and individual retirement accounts.

While there are benefits to maxing out annual contributions to these accounts, most people won’t have enough saved and invested in their IRAs to meet their needs and they shouldn’t be automatically excluded from the unique benefits of annuities. Annuities offer features standard retirement accounts lack even if annual contributions to standard retirement accounts are maxed out.

Annuities can offer a guaranteed interest rate and guarantee that you and your spouse receive guaranteed income for life. Annuities can also lock in some or all the death benefits mentioned above for you and your heirs.

And, finally, annuities are the only product that can guarantee a stream of income that you can’t outlive.

4. If I die, the insurance company keeps all my money

True, with some annuities, if you die the insurance company keeps your money. This is how they’re able to cover the payouts for other annuitants – it’s how a lot of insurance products work. But this usually only applies to life-only annuities, otherwise known as immediate annuities. If this is a concern for you and your family, don’t buy a life-only or immediate annuity. There are other options.

What’s also true is that most annuities are designed to give a payout to your beneficiaries when you die. To ensure your heirs receive such a benefit, buy an annuity that offers beneficiary benefits, as we discussed on episode #298 of the Queer Money® podcast.

Another consideration is purchasing a variable annuity. Variable annuities often let annuitants withdraw money early with a surrender fee, usually 10% like 401(k)s, and taxes similar to 401(k)s.

5. Annuities are expensive

Just like some stocks are expensive (hello Tesla! hello, Berkshire Hathaway!), some annuities are expensive, such as many variable annuities. Some annuities aren’t expensive, such as many fixed annuities. The more expensive annuities have their benefits. Do your research to find out what features you need in an annuity and balance that against what you’re willing to pay for an annuity. Better yet, talk with our friends at Gainbridge.

Some ways to keep your costs down are to look at only fixed annuities. Most fixed annuities have no maintenance or annual fees. Also, limit the number of riders you purchase. Adding riders adds to the overall cost of your annuity and may also trigger a maintenance or annual fee. Likewise, commissions are higher for complex annuities because the selling agent must do more work.

While surrender charges can be expensive, some withdrawals have exceptions such as for disability or long-term healthcare needs. Withdrawals are commonly free from surrender charges to cover nursing home expenses if the annuitant is diagnosed with a terminal illness or needs to satisfy IRS-imposed required minimum distributions (RMDs). It’s also good to know that surrender charges typically decrease over time.

With all that said, it’s important to remember you’re paying for:

• Guaranteed lifetime income for yourself and/or your spouse
• A means to generate income after retirement
• Principle protection
• Death benefits
• Tax-deferred growth

6. I should only consider an annuity closer to or in retirement

Look, we’ve now covered annuities on several podcasts and wrote this article because we think everyone should be open to all the financial planning tools that are available to them. Because of how annuities were created and sold in the past, too many people discount annuities without doing any research.

But today’s annuities aren’t your grandparent’s annuities. It’s also likely that your grandparents had both pensions and Social Security to support them in retirement. It’s likely, unfortunately, that you don’t have a pension. An annuity can be a substitute for a pension.

That said, immediate annuities tend to be popular with retirees and deferred annuities are more common for saving before retirement. But assess your wants and desires and talk with a financial planner or insurance agent about the type and structure of an annuity that may be best for you.

Finally, certain annuities can help protect your future income from market volatility and some annuities can help protect you against inflation. Market volatility and inflation will both become greater concerns as you age, and you may appreciate this annuity protection.

7. It’s stupid to get an annuity when interest rates are low

Warren Buffett famously said once, “Stop trying to predict the direction of the stock market, the economy or elections.” We’ll add “stop trying to predict where interest rates will go and what the fed will do.”

No one knows what the fed will do tomorrow, not even the fed. Plus, the fed is playing a short game and, with retirement planning, you’re playing the long game.

Pro annuity tip: The free look period

Finally, it might be helpful to know that most annuities offer a ten to 30 day “free look” period. That is, most insurance companies or financial services firms offer prospective annuitants a period immediately after purchasing a contract when you can cancel the contract and have your money refunded.

So, try an annuity and “return it” if you don’t like it.

All in all, annuities are just another tool to add to your financial planning toolbox. Hopefully, we’ve given you enough information about annuities to pique your interest in how they may help you and your loved ones. Now, talk with a professional, like our friends at Gainbridge.

Gainbridge Insurance Agency on the Queer Money® podcast

Do you want guaranteed income in retirement but aren’t sure if an annuity is right for you?

How do you even know if an annuity is a good tool for you—or someone you love?

We get a lot of questions about annuities from members of the LGBTQ community. But every person’s circumstances are different.

So, today we’re posing five specific scenarios to an expert to find out who is an appropriate candidate for buying an annuity and who isn’t. And one of these scenarios might just apply to you!

Sean Cox serves as Assistant Vice President of Digital Product Development at Gainbridge, a digital platform designed to help people protect their savings with guaranteed rates and tax-deferred growth.

On this episode of Queer Money®, Sean joins us to discuss how a gay couple in their 40’s might use annuities, describing how an immediate annuity provides guaranteed income for life, while a deferred annuity helps you grow assets for retirement.

Sean explains how a 65-year-old with a $50K nest egg might take advantage of a variable annuity and offers advice to a 45-year-old member of the FIRE community looking to earn a higher yield on their savings.

Listen in as Sean dispels the myth that you can’t access your money in an annuity and learn how annuities can help members of the queer community who receive lump sums of money (like an inheritance or discrimination settlement) maintain their financial security for the long term.

Topics covered on how to buy an annuity

• Sean’s advice for a gay couple in their 40’s to consider an annuity for retirement income
• How an immediate annuity provides guaranteed income for life
• What differentiates a flexible premium from a single premium annuity
• What it means to add a guaranteed period to an immediate annuity
• How a deferred annuity helps you grow assets for retirement
• Sean’s advice to a 65-year-old with $50K in savings who wants to retire right away
• How a variable annuity works and what it means to add a guaranteed growth rider to your annuity contract
• The myth that you can’t access your money in an annuity (and what penalties you might incur for taking money out early)
• How a financially independent 45-year-old with plans to retire early might use an annuity as part of a layered emergency savings fund
• How a 60-year-old gay man with AIDS could use an annuity to avoid losing his social security disability benefits due to an inheritance 
• Sean’s advice to a lesbian with a $200K settlement from a ®workplace discrimination lawsuit 
• How a fixed indexed annuity guarantees you’ll never lose money

Connect with Sean

• Gainbridge 
• Call (866) 252-9439

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Resources on how to buy an annuity

• Gainbridge Education Platform
• ABLE Accounts
• How to Talk About Annuities with Mom & Dad on Queer Money® EP302  

More tools to prepare for retirement:

• 7 Basics You Should Know about Annuities
• How to Pay Off Credit Card Debt in 2022
• How to Talk about Annuities with Mom & Dad

Note: This article is sponsored by Gainbridge, meaning we received compensation to write this article. That said, we only recommend products we use or thoroughly vet and would recommend to our moms. Talk with a professional before buying or investing in any financial product to make the best decision for you.