When an Annuity Is a Good Idea for Retirement (and When It's Not)

When it comes to planning your retirement, there's often a lot of confusion. While socking money away to earn tax-deferred interest is a pretty simple concept, the wide variety of ways you can do that can be head-spinning--especially if you're not a numbers person and have no experience in financial management. But many people worry that just sticking with an off-the-rack 401k from their employer might not be the best approach, so they start investigating alternatives. Eventually, someone will suggest an annuity.

And just as quickly, someone will rush over to tell you, in no uncertain terms, that annuities are a bad idea. The aging disagreement about annuities comes down to two simple facts: Annuities can be complicated, and they aren't right for everybody. But if you're taking a more active role in planning your retirement, an annuity is worth considering. Here's what you need to know.

Types of annuities

The first question everyone has when it comes to annuities is: What the heck is an annuity? You might kind of know that an annuity pays you a guaranteed income of some sort--that's the top-line selling point when it comes to retirement planning. But an annuity isn't so much an investment or bundle of investments (like a 401k or IRA) as insurance on an investment. First, you pay a company a lump sum or a series of payments and agree to let them manage it for a period of time (known as the "accumulation period"). When the "annuitization period" begins, they guarantee a certain amount of income regardless of how the market goes. If the economy tanks, your IRA will tank with it (for a while, at least), but an annuity will keep paying out.

That's the nutshell version--it gets more complicated, because there are several different types of annuities:

Fixed. With a fixed annuity, you pay in a lump sum or a scheduled series of payments, and you know from the outset what your return--the annual or monthly income you'll get out of it for the duration of the contract (for example, ten years)--usually from the very beginning. Some fixed annuities only guarantee the amount of income for a period of time, while others guarantee it for the whole term. If guaranteed for the whole term, that income is fixed and doesn't change, no matter what happens to the principal or interest rates. One obvious downside with a fixed annuity is that inflation and other factors may make that income insufficient in the long term. Variable. In a variable annuity, the income you get back once the annuitization period begins does vary based on the performance of an investment package that you select. There's more risk here because your income can dip precipitously--but some variable annuities offer an optional minimum income provision that you can pay for to reduce that risk. Immediate. Most annuities have a deferred annuitization period, meaning it doesn't start paying you income for a fixed period of time. But you can purchase an annuity product that begins paying you very quickly, usually within a year, which can be attractive if you're already retired and want to have some secure income as insulation against rocky market forces. Lifetime. Most annuities have a term--a period of time the insurer agrees to pay you an income. A lifetime annuity only ends when, er, you do, and even then you can often buy a rider that will pay the income to a spouse or partner after you pass. These annuities usually have significantly lower income levels because of the additional risk the insurer is taking on.

Pros and cons

Buying an annuity seems pretty straightforward--for a certain amount of investment, you get the benefit of a steady, sometimes guaranteed income for a set period of time or even the rest of your life. Retirement has a lot of uncertainty, especially when it comes to your investments and whether they will support your needs as you age, so this is a comforting idea.

And there are some good reasons to consider an annuity:

Stability. Knowing your income has a "floor" that won't change is incredibly useful, even if inflation or other costs of living rise. Tax-deferred. During the accumulation period of your annuity, your money usually grows tax-deferred.

But there are also some downsides to consider:

Expensive. Annuities usually require a pretty hefty buy-in; annuities typically cost about $100,000 in investment for $500 of monthly income once you hit retirement age. And your investment isn't insured by the Federal Deposit Insurance Corporation (FDIC), so the only guarantee you'll get paid is the existence and good management of the insurer you purchase the annuity from. Also, there are a lot of fees associated with annuities. If you try to pull your money out before the accumulation period is over, those fees can be eye-watering, and annuities typically charge high maintenance fees that can sometimes be as high as 10% of the value of your investment--and the fee structures are often difficult to understand. Taxes. The accumulation period may be tax-deferred, but the income you receive will be taxed--and it will be taxed as ordinary income. That means it will be a higher tax rate than what you'd pay on income from capital gains, so you might be in for quite a shock when the tax bill arrives. Complex. Perhaps the biggest complaint about annuities is their complexity--you often get a hard sell on annuities, and salespeople often try to "bottom-line" it as guaranteed income. But the contracts can be dense and it can hard to quantify whether you're getting a good return on your investment or not.

So, should you consider an annuity? It's a complex question and everyone's financial situation is unique, but should probably only consider one if you answer "yes" to both of the following questions:

Do you have extra money? That's not a joke. If you've already put the maximum amount of money into other tax-deferred retirement accounts like your 401k and IRAs and you still have a lump of cash burning a hole in your bank accounts, an annuity can be a good way to put that money to work in an additional tax-deferred vehicle.

Are you very risk-averse? The main draw of an annuity is the predictability of it. If the ups and downs of your retirement accounts make you queasy, having an annuity can ease some of that stress.

Do you have extra money? That's not a joke. If you've already put the maximum amount of money into other tax-deferred retirement accounts like your 401k and IRAs and you still have a lump of cash burning a hole in your bank accounts, an annuity can be a good way to put that money to work in an additional tax-deferred vehicle. Are you very risk-averse? The main draw of an annuity is the predictability of it. If the ups and downs of your retirement accounts make you queasy, having an annuity can ease some of that stress.

If you're a "no" on these, you probably don't need or want an annuity. If you're unsure, calculate what the worst-case scenario of your retirement income will probably be, including Social Security. If it's still enough to cover your expenses, your money will probably do more work for you in a different investment.