Invest or Buy an Annuity? Which Makes Sense For You?

At their core, an annuity is a contract between an investor and an insurance company. Investors hand over a lump sum of money or through multiple payments to the insurance company, which invests the assets and guarantees certain payouts or returns on that money. Through the process of annuitization, investors can take lump sum withdrawals and set up monthly income payments for life.

Annuities come in basically two forms: deferred and immediate. Deferred annuities are generally designed for accumulation and savings of assets. Variable, fixed, and indexed annuities fall under this category and serve to help investors save for retirement or other long-term needs. Immediate or income annuities are designed to provide income to an investor right away or at some date in the near future.

Keep in mind that this is a very cursory overview and that many of these products come with their own eccentricities and points. However, a quick understanding of the two styles can serve as a conversation starter for whether or not investors should consider an annuity in the first place.

If you are looking to accumulate money, a deferred annuity may make a good choice for your portfolio. The chief selling point of these products remains their ability to offer tax-deferred growth and in some instances tax-free withdrawals. This makes them ideal for savers who have already maxed out retirement plans such as a 401k and their IRAs. Deferred annuities generally do not have contribution limits, meaning high income savers can potentially push more money into one of these products than a workplace plan or IRA.

Additionally, workers who do not have access to a workplace retirement plan like a 401k or 403b at all may find a deferred annuity helpful as limits on IRAs remain low.

A fixed or index annuity may have plenty of appeal for older workers or those in pre-retirement stages. These products either promise a fixed rate of return or returns tied to a stock market index with potential price floors. For pre-retirees, this guaranteed rate of return or loss-limiting ability can help reduce sequence risk and reduce volatility heading into retirement. You can let the rest of your portfolio run, knowing that you will have a portion of your portfolio safe when you hit your retirement date.

So, why not buy a deferred annuity? For one thing, costs. Because they are insurance products, there are a host of expenses that come along with those guarantees. As such, investors may be better off investing.

For example, variable annuities invest in various sub accounts that basically function like mutual funds. However, investors may find using a taxable account and low-cost index ETFs as better options. Thanks to ETFs’ creation/redemption mechanism, they are often very tax efficient. These days, you can run a taxable account nearly as efficiently as retirement vehicles. This is particularly true with low tax rates on long capital gains and dividends. Investors may actually win out versus the ordinary income rates that annuities are taxed at.

Additionally, a bucket approach may eliminate the need for fixed or indexed annuities. Having two or three years in cash for spending needs eliminates the worries about sequence risk. A portfolio can run, while an investor’s spending is insulated from market movements. This is practically advantageous now that cash is paying a much higher rate of return.

For investors looking for monthly income today, an immediate annuity could be the correct tool for their portfolio. Here, an investor hands over a lump sum of cash and an insurance company pays a monthly check for the rest of your life. Immediate annuities are wonderful tools for preventing longevity risks and making sure you don’t run out of money in retirement. At the same time, they remove market risk completely from the equation. It does not matter what the S&P 500 does; you know you’ll get $X every month for the rest of your life or period.

And there are plenty of reasons to do just that. For one thing, the risk of outliving your money is larger than many investors realize. A 65-year-old man in average health has roughly a 20% chance of living beyond the age of 93. With that, many annuities would offer a higher income payout over the longer haul than a portfolio. This is not even considering that portfolios can and do decline in value from market risk.

So, why not buy an immediate annuity? For one thing, most of us already have an immediate annuity: Social Security. If Social Security already covers your basic needs, then there is no reason to add additional income protection to your portfolio. Additionally, if your portfolio is already massive and you have sensible/small withdrawal expectations, the guaranteed income may not be needed.

One of the big hurdles for many investors is the amount of capital needed to buy income through an annuity. It takes about $350,000 for a 65-year-old male to generate over $2,000 per month income via an annuity. And remember that lump sum is irrevocable. Depending on initial portfolio size, that could leave some investors struggling to pay one-offs like medical expenses or unforeseen emergencies.

Don’t forget to check out this article to learn how the SECURE Act can impact annuities.

Annuities of all stripes have plenty of appeal for a wide range of scenarios. They can serve as accumulation devices or provide plenty of steady income. However, the decision to purchase one is not cut and dried. Ultimately, investors need to weigh all the pros and cons before buying one. In the end, a good mixture of regular investments and an annuity may be the best mix for optimal outcomes.

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