The thought of outliving your retirement funds with no way to replenish it can be worrisome for people over the age of 65. If you’re looking into purchasing an annuity, it’s best to research them thoroughly because if you pick the wrong one, you may end up paying too much in fees, or worse, you may lose your money entirely. Here we will cover five mistakes to avoid when shopping for an annuity.
Several types of fees accompany annuities and you will want to be familiar with these before you invest. Below are examples of fees that are charged for a typical variable annuity:
Mortality and expense risk charge: This fee is usually 1.25 percent per year, or equal to a percentage of your account value. This fee pays the insurer for the risk it assumes under the annuity contract. The profit from the fee pays a commission to the company or individual who sold you the product.
Administrative fees: You may be charged for paperwork, record keeping, and miscellaneous administrative expenses. This may be charged as a once-a-year flat fee or as a percentage of the value of your account.
Underlying fund expenses: These are the fees and expenses tied to a mutual fund investment. This expense is in addition to the fees charged by the issuer.
Fees and charges for other features: You may incur fees related to special features, such as a guaranteed minimum income benefit or long-term care insurance. Other miscellaneous fees may also apply.
Penalties: If you withdraw money from your annuity before you are age 59 ½, you may be required to pay a 10 percent tax penalty. This penalty is in addition to any taxes you owe on the income.
Surrender charge: A surrender charge is a fee paid to withdraw some of or the whole principal amount before the annuity’s surrender period has expired. A surrender period is usually six to eight years after you purchase the annuity. Withdrawing or selling funds too early results in a surrender charge and reduces the value of your annuity.
While annuities are a good source of extra income during retirement, they can be inflexible. Immediate annuities typically pay out more than other fixed investments. For example, if you invest $100,000 in an immediate annuity, you can get around $6,912 per year for life, according to ImmediateAnnuities.com. But you’ll have to give up control of your money to get this extra income. With an immediate annuity, after you give the insurer your lump sum ($100,000), you can’t take it back.
Even with a deferred annuity – annuities that let you withdraw money after you invest it – you could risk losing your income guarantees if you withdraw more than five or six percent of your guaranteed annual value. This is why it’s a good idea to think about the amount of your retirement funds you’d like to invest in an annuity.
A good rule of thumb for calculating how much to invest in an annuity is to work backward. Add up the expenses you expect to pay during retirement, subtract the money you’ll be getting from guaranteed sources like a Pension or Social Security and invest the difference in an annuity. You can then keep the remainder of your money in other investments where it remains accessible.
Keep in mind, choosing the highest payout option when it comes to annuities might not always be the best option. A single-life version of an immediate annuity (stops paying when you die) will get you a high annual payout. But if you pass away and your spouse is still alive, the single-life immediate annuity still stops paying, which isn’t good if your spouse relies on that income. In this case, it would be better to take a lower payout annuity that will continue for you and your spouses’ lifetime.
Using the example of the 65-year-old man who invested $100,000 in an immediate annuity, his annual payout would go from around $6,912 per year to around $5,800 per year if he bought a joint-life annuity with payouts continuing for as long as he or his spouse lived.
Annuities work by investing the money you pay in today for a guaranteed future return. So it’s important to account for the ever-increasing rate of inflation. If you do not factor in the inflation rate, your money will be worthless when it comes time to withdraw. To remedy this, calculate how much you will need and then adjust the number for inflation, or you can buy an annuity that comes with built-in inflation protection. With an inflation-adjusted annuity, the payments are adjusted for inflation annually based on the yearly rise in the cost of living (U.S.). This automatically increases the benefit amount as inflation rises.
When an investor buys an annuity from a provider, the money is invested to receive a rate of return (fixed, variable, and indexed). At retirement, the annuity is converted to regular payments you receive for the rest of your life. But if an insurer is not able to make the payments for any reason, you won’t receive your money.
That is why it’s best to choose an insurer with a good rating and solid track record. Look for an insurer that has a high rating with Standard and Poor’s, Moody’s or A.M. Best. These three companies keep an eye on the performance and the financial health of insurance providers. Choosing a provider that has an “A” rating from A.M. Best, or an “AA” rating from Moody’s or S&P lets you know the company has a solid reputation.
All brokers, dealers, and investment advisers that sell variable annuities should be registered with the Financial Industry Regulation Authority (FINRA). Visit FINRA’s BrokerCheck website for information on a brokerage firm’s or individual broker’s qualifications and background. Do a search by name or registration number. Also, BrokerCheck provides links to state regulators’ websites, which can assist you in making an informed choice.
Most seniors should consider an annuity only after they have maxed out other available tax-advantaged investments such as IRAs and 401(k) plans. If you have additional money to invest for retirement, an annuity’s tax-free growth can make sense, especially for those who fall into a high-income tax bracket. Keep in mind that any earnings you withdraw will be taxed as regular income.