Several strategies can help you build your retirement income, including contributing to an employer-based 401(k) plan, opening an individual retirement account (IRA) or brokerage account, and purchasing an annuity. Annuities have long been a strong addition to financial portfolios, but as the financial landscape changes, so might your investment and financial planning strategies.
Given the current economic climate, purchasing an annuity may or may not be the right approach for you, depending on your retirement plans. Reviewing some of the pros and cons of annuities can help as you make this decision.
An annuity is an insurance product that essentially guarantees retirement income. With an annuity, you make either a lump-sum payment or periodic payments to an insurance company, and they pay the money back to you with interest either as one lump sum or at regular payment intervals. There are fixed, variable and indexed annuities, and each provides a different rate of return, which could be fixed or change based on market performance.
The main benefit of annuities is that your money earns interest over time. They also come with significantly less risk than investing in the stock market, especially if you choose to purchase a fixed annuity with a guaranteed rate of return. However, with the current recession and low-interest-rate environment, an annuity might not be right for everyone. You'll have to weigh several factors before deciding whether to include this financial product as part of your retirement strategy.
Pros and Cons of Annuities in 2021
At the beginning of the COVID-19 pandemic, the markets hit significant highs and lows seemingly every day. Now, even on a good day, the stock market is still filled with uncertainty. However, the rapid fluctuations that investors saw in their retirement portfolios caused many to take their money out of the stock market and stash it in safer places. In some cases, people had no choice but to use their retirement savings to cover their expenses.
One study from MagnifyMoney found that 30% of people saving for retirement withdrew money from their accounts in 2020. What's more, 54% of people surveyed by the Center for a Secure Retirement said the pandemic had negatively affected their retirement planning, and 36% of them said they had lost money in the stock market.
The stock market has largely rebounded from the lows it experienced in early 2020, but if you're planning for or nearing retirement, you still might be worried about how the market will perform in the near future. If so, it's important to weigh the pros and cons of annuities.
Advantages of Annuities
An annuity can offer some level of protection against severe losses because you get either a fixed rate of return or a baseline return with the potential for increases based on the market's performance. However, this is only the case with fixed and indexed annuities. Variable annuities come with more risk since they fluctuate entirely based on the market's performance.
If you're nearing retirement, you might be concerned about protecting what you've already got saved. Investing in an annuity can help you do so, as it will safeguard some of your savings from swings in the market and provide guaranteed income in retirement.
You may be able to structure an annuity contract in different ways, depending on the insurance company you choose. For example, you could include a death benefit in the contract (similar to the benefit offered in a life insurance policy) to ensure your loved ones receive some form of an inheritance when you pass away.
Disadvantages of Annuities
One thing to consider is that with low interest rates, you might not get as high of a return, especially with a fixed annuity, which is based on the yields from government bonds and high-quality corporate bonds that an insurance company holds. If your retirement is still years away, then you might not be willing to deal with lower returns in exchange for lower risks. Instead, you may want to aim for a higher rate of return on your investments now because you'll have years to recover if the market drops again.
Limited Flexibility and Potentially High Fees
With an annuity, you'll trade flexibility for earning a fixed or baseline interest rate on your money, depending on whether you choose a fixed or indexed annuity. This means you won't be able to access your money in an emergency if you need it. In some cases, you might be able to pay a surrender charge or a 10% federal tax penalty to make an early withdrawal from an annuity, but doing so would reduce your retirement savings. Annuities also come with various administrative fees, so you'll need to factor these fees into the total costs of owning an annuity.
It Depends on Your Personal Financial Goals
You might want to incorporate a retirement annuity into your financial plans if you have additional savings and are looking for guaranteed income with minimal risk. However, if you want more flexibility and a higher rate of return — especially given current interest rates — then you might want to focus on tax-advantaged accounts, such as a 401(k) or an IRA.
Either way, make sure you understand the advantages and disadvantages of each option and create a plan that's tailored to both your current financial needs and your retirement savings goals. Talking with a financial professional can help you nail down the details and figure out what's best for you.