What Are Annuities?
Plus An Alternative For DIY Investors
What is an Annuity?
An annuity is a contract between you and a financial institution, in which you make a lump sum payment to the company and in exchange, they make a series of monthly payments back to you.
Why do People Use Them?
People use annuities to ensure that they have a predictable stream of income during retirement. You can choose if you want to start receiving annuity payments right away or at some point in the future.
If you choose to receive payments at some point in the future, the lump sum you deposited will be invested and grow at a tax-deferred payment. The idea being when you finally do want to receive payments, your money has grown and your payments could potentially be larger.
You can also choose how long you want to receive those payments. The two most common annuity timelines are 25 years or until death. Each choice has an opportunity cost. If you choose to receive payments for 25 years your payments would be larger but you run the risk of outliving your annuity payments. If you choose for payments until death you guarantee you’ll never run out of payments, but your monthly payments will be smaller.
Types of Annuities
There are three main types of annuities:
- Fixed annuities
- Variable annuities
- Index annuities
Fixed annuities pay out a guaranteed amount for the length of your annuity term. If you chose a fixed annuity until death you could guarantee yourself a predictable stream of income for the rest of your life. However, to guarantee a fixed payout requires the annuity firm investing your money in zero risk assets. That means you are locking in a lousy rate of return and will likely end up receiving smaller payments.
Variable annuities allow you to be more aggressive with your investing approach. You choose from a list of mutual funds and your monthly payments during retirement are based on the performance of those funds. If they do amazing you get more money, if they tank you get less money.
Index Annuities are the “happy medium” in between fixed and variable annuities. You will have a guaranteed minimum monthly payment, but the payments beyond that are tied to the performance of a stock Index, typically the S&P 500.
Watch Out For Fees
Annuities sound pretty awesome right about now, what’s the catch? The catch is that there are a number of fees associated with annuities that can eat away at your hard earned retirement cash.
Surrender fees. These are the fees you will pay if you decide to pull your money out of the annuity early. The more time that is left until the end of the annuity, the larger the fees.
If you had a 25 year annuity and you decided to pull your money out in the first year, you might have to pay up to 7% of your savings in surrender fees. YIKES!
Commissions. Don’t forget most annuities are provided by insurance companies which means you probably bought the annuity from a salesperson. That salesperson will receive a commission for that sale that could be up to 10%. In case you were wondering who is paying that commission, you are.
You can potentially avoid paying a large commission by cutting out the salesperson and buying an annuity directly from a brokerage like Vanguard or Fidelity.
Annual fees. The more active investment required within your annuity, the higher the annual fees you will need to pay. Variable annuities, for example, might have;
- Insurance charges that could run as high as 1.25%
- Investment management fees that could be as high as 2%
- Various other insurance fees that could be as high as 0.5%
If you go with a fixed annuity you will likely have lower annual fees, but the fact is, annuities come with a lot of fees attached.
If you are a frugal, DIY investor you probably cringe at the idea of paying this much in fees. If you’ve been paying less than 0.15% in fees on your investments during your working life the idea of paying up to 3% per year during retirement does not sound appealing.
You might be asking, is there a way I can live off my retirement savings and avoid paying huge fees? I’m glad you asked.
The 4% Rule
The 4% rule is a rule of thumb to help ensure you don’t run out of money during retirement. The 4% withdrawal rate refers to how much of your retirement portfolio you liquidate in the first year of retirement, this acts as your base year
In the proceeding years after retirement, you withdraw the same dollar amount you did in the first year plus inflation. The major assumption is that your investments have an average return that is 4% higher than inflation during retirement. If that is the case, you should not run out of money.
Like many other “rules of thumb” the 4% rule can be adjusted based off your risk tolerance. Some people who are confident in their investments use a 5% rule while others that are more conservative might use a 3% rule. No matter which version you choose, the 4% rule can act as a guide for the DIY investor who wants to plan out how to live off their retirement savings while ensuring they don’t outlive their money.
The major plus for using the 4% rule is you avoid all of the fees associated with annuities. But be careful, it is simply a “rule of thumb” not an absolute guarantee. If you are nearing retirement it’s best to sit down with a financial advisor to figure out a more detailed financial game plan in retirement.
This article is for informational purposes only not all information will be accurate. This should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.
