What You Need to Know About Annuities

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Retirement researchers are often enthusiastic about annuities, but many consumers are reasonably skeptical. Here to discuss basic information about annuities and their pros and cons is Christine Benz, Morningstar’s director of personal finance and retirement planning.

This interview has been edited for length and clarity.

A: An annuity is a contract with an insurance company. In the most basic annuity type, income annuities, you give the insurance company a pool of your money, and they send it back to you as a stream of income over your lifetime. Those types of products give you more income than you could earn by investing in a bond.

They do that because you benefit in the annuity by what’s called “longevity risk pooling,” which means that some people who are buying that same annuity will die sooner, which enlarges the payout for the whole group of you. If you’re the one who lives to be 99, you’re the winner in that situation. That’s one reason that payouts are higher than you’d see for traditional fixed-income instruments. The other big reason is that if you buy an annuity, your money is gone, effectively. You get cash flows, but you can’t get your principal back. In contrast, when you buy a bond, you receive income, but you receive your principal back at the end.

A: These very basic income annuities can be helpful in terms of addressing a household’s basic living expenses. Say my household basic expenses—housing, taxes, healthcare—total $40,000, and Social Security is going to give me another $30,000 of that $40,000. I could buy an annuity that will supply me with $10,000 a year to help meet those basic cash flow needs. That’s an elegant use of an annuity, and it can help retirees figure out how much they would want to put into such a product, by examining how much they actually need from it.

A: The most familiar one is a variable annuity where you’re in control of the investment allocations. There are also increasingly popular “fixed index” annuities, where you get market exposure, but there are caps on your gains. There are also caps on your losses. Registered index-linked annuities fall between those two product types on the risk spectrum.

A: Typically, these products carry really long contracts with lots of fine print. That can be very difficult for consumers to wade through. You can hire an objective third party to help you understand what you might be getting into.

At a minimum, write down all of your questions. There are no stupid questions in this context, because transparency isn’t there for consumers. Ask about costs, withdrawals, and what you’re getting with this product that you couldn’t get with a very vanilla investment portfolio that would also give you more liquidity and more access to your funds. Until you have exhausted all of those questions, don’t sign on the bottom line. You also want to ask about the financial strength of the insurance company backing the annuity, because this is a long-term relationship. You need to make sure that they’re able to make good on whatever promises they’re making.

A: It depends on the account that you use to fund the annuity, but generally, you will owe taxes. You get some tax deferral as long as the funds are in the annuity, and then you’ll owe taxes on any money that hasn’t been taxed yet. If you put pretax dollars into an annuity and it makes investment gains, all of your withdrawals will be taxable at your ordinary income tax rate.

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This article was provided to The Associated Press by Morningstar. For more personal finance content, go to https://www.morningstar.com/personal-finance

Christine Benz is Morningstar’s director of personal finance and retirement planning.

Related links:

1. A Retirement Readiness Checklisthttps://www.morningstar.com/personal-finance/retirement-readiness-checklist