Pros and Cons of AnnuitiesGuy Conger
Like any investment vehicle, an annuity has both good and bad points. The two biggest features in favor of an annuity are tax-deferred accumulation and safety. Historically, annuities have been very safe vehicles in which to invest and, with rare exception, there have been few defaults in this area. In addition, the tax-deferred accumulation allows for a significant additional accumulation of funds over and above what could be earned in a taxable vehicle.
However, you should remember that an annuity is a long-term accumulation vehicle. If the contract is surrendered prior to age 59 1/2, there is a 10% excise tax penalty levied. The advantage of tax-deferred accumulation is that eventually the additional earnings through tax deferral can offset this excise tax penalty. As a rule of thumb, you should plan on holding a deferred annuity approximately 15 years before liquidation (this can change depending on your tax bracket), if you plan on having your liquidation occur prior to age 59 1/2. This break-even point is reached sooner if the liquidation will occur after age 59 1/2. The holding period defines the break-even point between an annuity with tax deferral versus a similar investment at the same rate of return without tax deferral.
Another advantage for some in using an annuity is the selection of an annuitization (payout) option and the ability to guarantee an income for life. As one gets older, the annuitization factors rise because of the risk of the payout being over a shorter period of time for the insurance company due to a decreased life expectancy. With the rise in factors comes a corresponding additional payment that relates to a higher equivalent rate of return when comparing the annuitization payment received versus interest received on an account using the same initial lump sum invested. For some individuals, this certainty of continued income and the peace of mind it affords are important factors.
Again, as with any investment vehicle, there are disadvantages to the annuity and annuitization. Since your money is placed with an insurance company in an annuity contract, you have little control over the rate of return on your investment. A good company will pay a return competitive with that credited on 52-week Treasury bills and it should typically be slightly higher than this rate. However, the decision as to the crediting rate is entirely the insurance company’s and you should be aware of this when making an investment decision.
In addition, although there is certainty in your continued monthly income payment when choosing an annuitization option, you definitely have purchasing power risks associated with this decision. Although you have eliminated the possibility of market risk on your investment because you have locked into a fixed rate of return, you have created the risk of loss of purchasing power. Your income will be a fixed income that will not have the flexibility of readjustment in case of higher inflation rates. In addition, annuities provide less flexibility for leaving an estate to your heirs if that is your wish. There is some flexibility in that an annuitization option can be chosen that allows the potential for remaining funds to pass to heirs. However, remember that any option such as this will reduce the amount of payout to you during your lifetime, since it corresponds to a lower annuitization factor and thus a lower monthly payment.