Breaking Down the Basics of Annuities

There is often an inverse relationship between the perceived complexity of a retirement investment and its adoption in the marketplace. Lifecycle (target-date) funds, which we covered recently here—are at the more simple end of the complexity spectrum. For many, annuities are at the other end of the spectrum. For that reason, and several others, annuities are often ignored by investors.

But the key advantage an annuity offers—guaranteed income in retirement—is too important to completely ignore—complexity or no. While the topic of annuities is large enough to fill a textbook, we’ll break it down into smaller bits in a 4-part series over the next few weeks:

• Introduction to annuities (today’s article)
• Types of annuities and different stages of accumulation and distribution
• Advantages and disadvantages of annuities
• What you need to know before, during, and after investing in annuities.

What Is an Annuity?

An annuity is essentially a life insurance product that changes over time into a series of payments for the investor. Life insurance pays an insured beneficiary upon death, while annuities pay the insured while they are still living. The idea behind annuities dates back centuries, but recent changes and additions to annuity offerings have made them a more attractive investment vehicle than they once were.

Still, there are several kinds of annuities—fixed and variable—and several stages of investment in an annuity. So even a quick, simplified breakdown of annuities isn’t all that quick or simplified. Ironically, an investment vehicle designed for simplicity is anything but. So, before we lose you, let’s talk about the…

Advantages of Annuities

We’ll summarize the benefits here and probe more in later articles.

• Tax deferral: All money invested into annuities of any kind grows tax-deferred until it is withdrawn. A key advantage for high-income investors is that, unlike many other investments, you can make unlimited contributions to annuities.
• Guaranteed payout: With any annuity, choosing a life payout option means an annuitant will receive some sort of payment until they die.
• Protection from creditors and exemption from assets: Annuity contracts are (with some state-level exceptions) exempt from creditors and probate proceedings nationwide.

There are, of course, some …

Disadvantages of Annuities

The cons of investing in annuities often depend on the type of investor you are and the type of annuity you invest in, but they can include:

• Costs and fees: Much of annuities’ bad reputation in the marketplace comes from the simple fact that they are one of the most expensive types of investments available in the financial marketplace. This is not a myth.
• Taxation: How can we list tax deferral as the key benefit of annuities, and then “taxation” as a disadvantage? Because all withdrawals from an annuity are taxed as ordinary income, regardless of how long the investment was held.
• Lack of liquidity: You can withdraw money from an annuity, but it will not easy, and it will come with a penalty—in some cases a substantial penalty.
• Complexity: Have we mentioned this? Even experienced investors may not understand how annuities work and may misuse them in their investment portfolio. We’ll discuss in future articles how to avoid the missteps.

In future articles, we’ll get into the details of annuities and why they are an important investment option for physicians and other healthcare providers.