In simple terms, an annuity is a contact between a person and a company. The person gives the company a sum of money, and in return is promised a monthly payout, generally for the rest of their life. There are many cases where annuities make sense for retirees or folks planning to retire soon. At the same time, there are risks and situations where annuities are the wrong choice.
You are very likely better off with no annuity as opposed to the wrong one. The first challenge is finding out whether an annuity could work for you.
In the old line of thinking, annuities were considered a product for anyone – essentially a way to purchase your own pension. As a result, many people wrongly placed their entire investment portfolios into annuities.
When you think about it, investing your whole portfolio into a single investment doesn’t make sense for any financial instrument. These investors put themselves at considerable risk by placing all of their eggs in a single basket. They were also often whacked with innumerable hidden fees on their life savings. Many saw their monthly income drop as the investment markets took a tumble.
Because of this situation, many states now regulate the percentage of annuities you can hold in your portfolio, and for good reason. If you’re thinking about putting annuities into your portfolio, first consider a limit on the total.
The second big consideration is whether you’re looking to invest or simply to secure cash flow. Although annuities are often sold as investments, they shouldn’t be thought of as an investment product. They’re an insurance product – a contract between a person and a company – and you should only buy them for the guarantees in the contract.
While an annuity may turn out to be a good investment, that’s not the right reason to buy one.
If you want an investment, the market is full of mutual funds, ETFs, stocks and other investments. Accessing the stock market through annuities is an expensive and roundabout method. Essentially, you’re paying a middleman, the insurance company, to invest in the stock market. It’s much simpler to just do it yourself. If you’d prefer not to, professional money managers typically charge lower fees than annuities.
If they’re not an investment, when do annuities make sense? We recommend a person buy an annuity for what it will do (contractual guarantees), and not what it might do (hypotheticals).
In too many cases, folks buy annuities thinking they have guaranteed income based on potential earnings in the future. If the income is based on a formula or index, the guarantee is only the method used for calculation. It does not mean your monthly checks will always be the same.
One member of the Money Forever team summed it up pretty well with a single question: “Have you ever heard of a hedge fund investing in an annuity?” No, I can’t say that I have. It’s absolutely amazing the sort of things they can make a buck on – from stocks and bonds to mortgage-backed securities and interest-rate swaps. And yet you won’t find annuities in their portfolios. If the smart money isn’t investing with annuities, maybe the average Joe should take the hint.
So if you’re looking at an annuity as an investment product then you should probably look elsewhere. However, if you’re looking for a steady payout during retirement—and you’re willing to read the fine print to understand exactly what’s being promised to you—then you might be a good candidate. To see if you are, I suggest you use “The 8 Point Guide” to see if an annuity might fit your circumstances.