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Answer These Questions Before You Consider Buying an Immediate Annuity

At times, retirement seems like a multiple-choice test with no wrong answers. That’s because the questions depend on individual variables such as your current finances and financial goals.

Consider, arguably, the biggest retirement question: How do I avoid outliving my money? One possible answer is an annuity, which can provide a guaranteed stream of income, but at the price of a hefty commission.

In the 2013 Survey of Owners of Individual Annuity Contracts, nearly 90% of respondents said guaranteed income was an important part of annuities and that they use them as “a financial cushion in case they live well beyond their life expectancy.”

There are various types of annuities which often contain many caveats, but let’s focus on immediate fixed income annuities, as they are the simplest. Basically, you pay a lump sum that is invested by the insurer in exchange for fixed monthly payments over the course of your life, or a specified time period.

Annuities date back to the Roman Empire, which used the financial device to compensate soldiers for their service. In modern times, annuities are associated with the more peaceful demographic of retirees; although, like the Romans, retirees may be just as ambitious in their conquests of life goals such as starting new businesses or traveling around the world.

Those particular goals, along with your personal finances, are what make your answers to retirement questions unique. It is why immediate annuities are not the only answer to the question about outliving your money. While guaranteed income is good for all, annuities are not. To help decide if buying an immediate annuity makes sense for you, start by answering these basic questions:

Do I have an income gap?

Retirement is funded by more than one income source. You may have Social Security, you may be fortunate to have a pension and you should have savings, which will generally make up your investment portfolio. If these income sources can fund your retirement objectives, then buying an immediate annuity is probably unnecessary.

If they do not and you have an income gap, consider first looking to your investment portfolio, because keeping your assets invested maintains their ability to grow. The assets used to purchase an annuity, on the other hand, lose that growth potential. But, in the event your portfolio balance cannot provide a sustainable withdrawal rate to meet your needs, an immediate annuity may supplement your other sources to create a dependable income.

Do my goals require flexibility?

Retirement is your oyster. You may choose to strive for new entrepreneurial pursuits or just to maintain your current living standards. No matter what your goals are, they require cash. Plus, since life expectancies are increasing, you may have a long retirement (see next question), which means higher chances of unexpected events.

Therefore, having easy access to money – liquidity – is an important quality in a retirement asset. Generally, annuities are illiquid products; you lose control of your lump sum and only have access to the predetermined monthly payment. If you need access to your investment and decide to withdraw your money early or cancel the agreement, you will be subject to high surrender fees. Hence, it is not recommended you invest a substantial portion of your savings in an annuity.

How’s my health?

As an annuitant, the longer you live, the more you win. That’s because for the first several years of an immediate annuity you’re being paid with your own money. If you die that money could be lost, leaving nothing to your beneficiaries.

Beyond that point, you start benefiting from the interest on your principal. Of course, as long as the insurance company itself stays in business, which a risk to consider if you do decide you need an annuity.

Do I want or need growth?

It’s important to remember that annuities are insurance products, not necessarily investments – you’re insured an income but not a return, as explained above. With an immediate annuity you have no control over how your principal is invested nor do you necessarily reap the potential profits. If you want the possibility of growing your money – to leave a legacy, for example – then an annuity won’t meet that need.

Additionally, inflation can diminish the monthly payments. If you rely on an immediate annuity for income, that will have adverse effects on your buying power over the course of your retirement. Some insurance companies offer inflation protection but at a higher premium.

Are the added benefits worth it?

Annuities can come with a lot of additional bells and whistles. These features, commonly known as “riders,” provide additional benefits such as long-term care or a refund of the remaining principal upon death. Of course, each rider comes with additional costs. Before buying, you will have to determine whether those features are right for your situation and whether or not they are worth the asking price.

Overall, an immediate annuity comes with certain tradeoffs. Does the guaranteed income outweigh the cost of locking up your money? Can you risk losing it upon a premature death? In general, an immediate annuity makes less sense for those with a substantial pension or savings. On the other hand, those with limited investable savings and a large income gap may want to consider its benefits.

Ultimately, an immediate annuity is another potential piece for your retirement puzzle. Depending on your financial situation and goals, it may or may not fit. Only by understanding the tradeoffs can you guarantee yourself from buyer’s remorse.