During times of economic uncertainty, it is common for people to seek out financial advice as they seek to answer the question: Am I going to outlive my money, or is my money going to outlive me? In response to this higher demand for advice on how to not outlive their money, many financial advisors suggest buying financial products—namely annuities—promising to prevent that exact situation. Additionally, many employer-sponsored retirement plans (i.e., 401(k), 403(b), etc.) are beginning to offer annuities to retired employees who desire a steady stream of income for their lifetime.
On the surface, this may sound like an intriguing proposition. After all, there are not many guarantees when it comes to personal finance. It is not surprising, then, that BlackRock’s 2021 study of defined contribution plan sponsors and retirees revealed “89% of retirement plan participants agree that having guaranteed income in retirement would have a positive impact on their current well-being.” However, if you are considering buying guaranteed income, it is important to dig beneath the surface to reveal exactly what you are purchasing.
What is “Guaranteed Income”?
At its core, guaranteed income is a way to turn your retirement savings into a reliable income stream you cannot outlive. Examples include an employer-sponsored pension plan, variable annuities with guaranteed income riders, and fixed annuities. Annuities are much more prevalent by far, as the number of employer-sponsored pension plans has decreased dramatically over the last few decades. Essentially, you make a lump sum or periodic payments to an entity (i.e., the pension plan administrator or life insurance/annuity company), and in exchange you receive a stream of—usually monthly—payments for the rest of your life. The amount of the payment is based on several factors, including the total amount you paid in, your life expectancy, and any additional features or benefits you added to the policy (e.g., guaranteed period, payments based on multiple lives, etc.).
What are the Advantages of “Guaranteed Income”?
There are several reasons you may consider buying into a guaranteed income product. First, it allows you to put away a larger amount of money than, say, contributing to a Traditional or Roth IRA. There is no annual contribution limit for an annuity (if buying an annuity using after-tax dollars), and, if the money is invested, any growth is tax-deferred until you begin receiving payments. Additionally, there is some amount of flexibility with respect to getting your money back, as you can typically choose between receiving a lump sum or monthly payments. Often, you are also able to add additional features or benefits onto the plan or policy, such as guaranteeing payments for a certain number of years (i.e., if you die prior to the end of the guaranteed period, your beneficiary can continue receiving benefits).
What are the Disadvantages of “Guaranteed Income”?
While you may be attracted to the benefits of these products, it is important to make your decision by balancing the pros with the cons. One of the main drawbacks of annuities is how complex they are: a typical annuity prospectus or contract can be 40 or more pages long. The insurance industry has created myriad variations of these products, each with their own unique fees, features, benefits, and drawbacks. These are often so complex the average investor has difficulty understanding exactly what they are being offered and how much they are really paying for it. Additionally, if you purchase the annuity through an insurance broker, the broker will earn a commission, which can be 5% of the contract value or more. Even if you are able to avoid this commission, the internal expenses of the contract can often be in excess of 2% annually. Annuities are also notoriously illiquid, due to surrender fees. Effectively, if you purchase an annuity and decide in the first 7 to 10 years to surrender, or cash in, the policy, you will likely pay a surrender charge, which can range from 1% to 10% of the contract value. If you purchase a non-qualified annuity (with after-tax money) and then elect to withdraw funds (i.e., not annuitize), you will pay taxes on any gains at regular income tax rates, unlike a traditional investment account with favorable dividend and capital gains rates. Finally, if you choose to begin receiving payments, two things typically happen: 1) you give up access to the capital you have invested, and 2) you cannot adjust the amount of the payments, no matter how much your monthly cash needs increase or decrease (e.g., due to receiving an inheritance or going back to work).
Ultimately, your decision to (or not to) purchase guaranteed income can be complicated and overwhelming. Thus, it is imperative to know exactly what you are buying and what alternatives there might be, or you may find that your retirement plan looks a lot different than you expected.
The information presented in this article is for educational purposes only and is not meant to provide individual advice to the reader. There is no guarantee the information provided above relates to your personal situation. All financial situations are unique and should be advised as such.