Step 88: Annuities

Step 88 of the 100 steps mission to financial independence: Annuities
Step 88: Annuities

Let’s look at one more pension option before we round off the pension series: Annuities. Sounds like something complex (and they certainly can be when they want to be!) but this step will break down their characteristics and benefits, as well as some of their disadvantages.

What are annuities?

Annuities are a financial product somewhere between an insurance and an investment option. Like any insurance, you buy annuities – in this case it insures you against living too long. Yes, you read that right. Whereas a life insurance insures against dying too early, an annuity insures you against living too long. An annuity provides a set monthly income that you get for the rest of your life after a certain age. If you are fearful that you might outlive your pension, i.e. that you might withdraw too much from your investment and / or pension fund and end up without any money at some point in your retirement, an annuity is a good solution as it gives you a guaranteed monthly income.

How do annuities work?

There are many different types of annuities with many different characteristics. First of you normally buy an annuity from an insurance company, pension provider or broker who then reinvests your money. It very much works like a mutual fund and the company you buy the annuity from will add in a profit margin of course so your money won’t grow very much over time due to the fees you pay. You can buy an annuity with all of your pension savings just before you retire or you can buy several smaller annuities over time. Annuities differ in the way that they are set up and some of the key variables include:

  • Fixed versus market dependable variable monthly income.
  • Payment for life versus those that offer it for a fixed number of years guarantee
  • Flat-rate versus inflation or cost corrected payments that increase each year.
  • individual vs joint annuity for both partners that keeps paying even when one of the partners dies (though usually less).
  • Some annuities also offer principal guarantee that protects the principal you put in even if the market crashes

Of course the more guarantees or security, the higher the price you generally pay.

Advantages of annuities

Much can be said about annuities but here are some of their advantages:

  • It’s a very simple way to guarantee a monthly income: you just pay a lump sum and then get an income for life.
  • You are covered for life (or at least can choose to take this option) so you don’t need to worry about outliving your pension or investments.
  • It offers a good alternative if you don’t have enough money in your pension funds.
  • You can decide to buy various smaller annuities over time instead of committing all your money to just one expensive option.
  • On a fixed monthly payment annuity, the market can drop significantly whilst you can live off you annuity without having to sell bonds and shares at sales prices (something you might need to do if your pension was all tied up in your investment portfolio).
  • The later you start withdrawing from your annuity, the higher the monthly payout.
  • Some annuities let you defer payout, meaning the money has time to grow in the meantime.

Disadvantages of annuities

Annuities also have some major drawbacks, including the following:

  • They lock in your money for a long period of time (i.e. forever – meaning: as long as you live)
  • Once you’ve made a decision on an annuity it can be nearly impossible to change it
  • The way rates and fees are calculated are often not very transparent
  • Annuities won’t make you much money. Even though your money gets invested in the stock market, due to the fees and profit margins, it won’t grow very much. If you’re still quite a bit away from retirement, you might want to just invest that money directly into the market (especially in low-fee index funds) so that it can grow.
  • Annuity income is normally taxable in most countries / states.
  • If you don’t go for a lifetime guarantee it might be better to invest your money in a low index fund as there’s normally no real benefit in an annuity that doesn’t offer a lifetime payout.

I know that was a lot of factual information, so let’s get straight to the point of what to do with all of this information.

Step 88 – Annuities – in detail

  • Even more than any other financial concept we have discussed up to now, whether or not an annuity is the type of investment or purchase that you should pursue depends completely on your risk tolerance, personal situation and pension forecast of course.
  • First of all sit down and look at the advantages and disadvantages stated above. Per bullet point indicate how much you agree / disagree or how important this is to you.
  • Even if you are still (many) years away from retirement, have a look at what’s on offer in your country from some reputable annuity providers. Compare prices, offers fees and guarantees. It’s good to at least have an idea of what you can buy with your money.
  • Consider whether you want to have the financial security (and potentially lower price) now by buying an annuity early or leave it til later (and potentially only a few weeks – months before or even into retirement) when you have a better picture of your pension needs and funds available.
  • If you feel that an annuity is a good investment for you, determine an age at which to start taking an annuity, eg. if you can live off your other investments until 75, and don’t start withdrawing til after, the monthly payouts will be higher. Of course this “plan” can still be adapted later on, but it can give you a provisional idea of when, how, what and how much.

I did kind of warn you that annuities were a little complex…  This step is called “annuities” and not “get an annuity” as in recent years they have lost their popularity due to some of the disadvantages described earlier. As always, only you can decide whether it is right for you or not, but remember that you are signing away your money for a LONG (and I mean long…) time, so make sure you read the small print before you sign anything.

Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.

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