If you're considering an annuity, start by understanding what you get

A guaranteed paycheck for life is an attractive retirement option, but there are other considerations when looking at annuities.

  • By Kevin McAllister,
  • The Wall Street Journal
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You’ve probably seen the commercials advertising annuities, but as common as the ads are, details about exactly what you get from buying one are scarce.

So what can purchasing an annuity actually do for you?

Often mislabeled or misunderstood as an investment, an annuity is a product designed by insurance companies to hedge against the chance you’ll outlive your retirement savings. Annuities, at their core, aren’t generally used as wealth-creation tools; rather, they are risk-management mechanisms.

Though there’s variety among the types offered, the common thread is the contractual element: You give some or all of your retirement savings to an insurance company and get a check each month in return. Guaranteed income is typically the selling point of any annuity, as most policies will continue to pay you until you are no longer around to sign the checks.

But as rock-solid as any annuity may be in design, there can be flaws with the idea of a guarantee.

In simplistic terms: You could compare using an annuity in your retirement strategy to bowling with the bumpers up. It can limit your exposure to market volatility as a way to ensure your retirement savings never completely hit the gutter.

Bumpers, however, won’t help if the whole bowling alley closes. Similarly, an annuity purchased from an insurance company that fails can leave you completely exposed, and judging the strength of a financial institution decades down the line is difficult even for professionals.

Those who are pro-annuity often refer to the relatively-low failure rate of insurance institutions as a point of strength, while those who are bearish are quick to point out the recent AIG scare. Considering the arguments of both sides can help you peel back the layers of what you’d actually be purchasing and understand why insurance companies are doing the selling.

Since your lifespan is a variable that you can’t fully plan for, annuities allow you transfer the risk of outliving your life expectancy and savings to a third party. In this case, that third party is the insurance company, and they will typically offer you variations of fixed or deferred annuities, both of which have payout timetables as their names might suggest.

The company may also offer varieties of payout structures. Some have amounts that are fixed, while others may vary based on the performance of the underlying investments. Whatever the contractual arrangement, you’re always buying peace of mind for the later part of your retirement in some capacity.

But the terms you get in return for that coverage may leave you wanting more, especially if you’re prone to thinking about annuities like any of your other investments. For example, an annuity purchase is a sunk cost. If your life ends before you expect it to, don’t count on the insurance company to pay out the remainder to your next-of-kin.

While that may register as a bad deal to you, the shared-risk model helps the insurance company subsidize the policies of those who do outlive their life expectancy, thus keeping the industry sustainable.

Death isn’t the only way to lose your money. For those who may unexpectedly need to access the funds before turning 59½, an annuity can prove costly. Withdrawals can be subject to penalties of 10% of the amount plus your usual tax rate, meaning the damage can be extensive.

Confusion around those caveats can be compounded by the insurance industry itself. The process of buying annuities can be different than purchasing other financial products due to regulations related to the sellers’ fiduciary responsibility.

Those rules mean you must be extra vigilant about any variations in the core annuity products and bring a healthy skepticism to any discussion about available options.

“Forget the bells and whistles,” the WSJ’s longtime personal finance columnist, Jonathan Clements, wrote of those options. “Instead, consider making a series of smaller annuity purchases over the course of five or 10 years—which you can stop if your health deteriorates.”

But healthy or not, the promise of income can be enticing to those who want a security blanket and protection from an economic downturn. An investment in the stock market will never be able to guarantee you a paycheck for life the way an annuity can, which leads some experts to advocate strongly for them.

“Annuities provide a method to ‘pensionize’ your retirement savings,” wrote David Blanchett, head of retirement research for Morningstar Investment Management. “There’s also the added benefit of things like favorable taxation and a higher potential spousal survivor benefit.”

Like any financial decision you make, the factors that influence your choice will be personal and can be unique. In his column, Mr. Clements laid out four of the most popular and straightforward options that can help retirees maximize their income.

But it’s important to remember that maximizing your retirement account may not involve an annuity at all, no matter how tempting the advertisements might seem.

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