Why you should consider annuities in your retirement planning

(Fool) -- Annuities are contracts between you and an insurance company. In exchange for a typically large sum of money, the company promises to pay you a lump sum at some point or, more often, a monthly sum.

The payments start immediately or at some point in the future and can make your retirement more secure. Annuities are well worth considering as part of your retirement plan. 

But there is a lot more to learn before you buy into any annuities, though, including the difference between fixed, deferred, indexed, and variable annuities. Here is a quick review of what you need to know. 

Where did annuities come from?

Annuities existed in the ancient Roman empire and possibly in ancient Egypt.

The more modern history of annuities and annuity-like arrangements can be traced back to Europe in the 1600s when several thinkers proposed similar arrangements.

Many people would contribute a sum of money into a pool, and thereafter would be paid a share of it regularly.

As members of the group died, the smaller pool of money would be divided between fewer people, permitting those who lived very long lives to continue to receive funding from it.

In America, annuities became commercially available in 1812. Over many years, they have grown into a big business, with sales of fixed and variable annuities totaling $192 billion in 2017.

Why I still hate annuities: Here are the reasons these investments are bogus

Annuity red flag Fixed-indexed annuities promise a lot, but returns can be lower than advertised

While investment accounts and retirement accounts can serve you well, they can fall in value whenever the economy slows down or enters a recession.

That risk can keep you up at night. Annuity income, on the other hand, is guaranteed -- as long as the insurance company behind it is solvent, that is, which is why you should only buy from top-rated insurers. 

Annuities can help prevent you from running out of money late in life, and if you're worried about inflation eating away at your money's purchasing power, annuities can address that risk, too. You can spend a little extra on your annuity in order to have your checks adjusted over time to keep up with inflation.

The last consideration is that as we get older, we often have less interest in keeping up with our investments, and less able to do so.

Our cognitive abilities decline over time, whether we're aware of that or not.

Annuities relieve us of much of the responsibility for our investment decisions, letting retirees just sit back and collect annuity checks each month.

Kinds of annuities

Before you buy an annuity, be sure that you understand the various different kinds : 

• Immediate annuities or deferred annuities  
• Fixed annuities or variable annuities  
• Lifetime annuities or fixed-period annuities 

Let's take a closer look at the main types you'll likely consider.

Fixed annuities

Fixed annuities offer fixed income -- a sum that's spelled out ahead of time, calculated, in part, based on prevailing interest rates.

Fixed annuities are the simplest annuities to consider and they're best for many people, too.

Below is a rough idea of how much income you might get from a fixed annuity based on quotes from early 2019.

Different insurers will quote different amounts, though, and the level of income you can get for your money will fluctuate over time as interest rates change -- the higher the rates, the greater the payouts. 

PERSON/PEOPLE	COST	MONTHLY INCOME	ANNUAL INCOME EQUIVALENT
65-YEAR-OLD MAN	$100,000	$570	$6,840
65-year-old woman	$100,000	$543	$6,516
70-year-old man	$100,000	$650	$7,800
70-year-old woman	$100,000	$614	$7,368
65-year-old couple	$200,000	$960	$11,520
70-year-old couple	$200,000	$1,062	$12,744
75-year-old couple	$200,000	$1,225	$14,700

Source: Immediateannuities.com, as of January 16, 2019.

Women are offered smaller monthly checks because they tend to live longer than men.

Also, a married couple will get less income per month spending $200,000 on a joint annuity instead of splitting it into two $100,000 annuities, one for each of them.

When one spouse dies, the joint annuity will have to keep paying the full amount to the survivor.

But if there are two separate annuities, the one for the late spouse would stop paying and the survivor would only receive income from his or her own annuity.

Deferred annuities aka longevity insurance

Fixed annuities can start paying you immediately, but there's another kind of annuity to consider that will start paying you after a specified period -- that's the deferred annuity.

 If you end up living a very long life, a deferred annuity can keep you from running out of money too soon. It can also be a good thing to buy while you're still middle-aged and working, setting it up to pay you throughout your retirement.

As an example, a 65-year-old man might spend $100,000 for an annuity that will start paying him $1,329 per month for the rest of his life beginning in 10 years at age 75, or $2,115 per month in 15 years beginning at age 80.

Deferred annuities deliver bigger payouts because the insurer gets to hang on to the purchase price and invest that money for years before starting to pay you. The insurer may also be banking on making fewer payments to you since you'll be older when you start getting those payments.

Variable annuities

While fixed annuities offer payments that are spelled out in their contracts, variable and indexed annuities offer income that's tied to the performance of the stock market or investments you've selected -- so the income they offer will vary. Variable annuities also generally have an accumulation phase when the money you paid to the insurer grows and a payout phase when the insurer is sending you checks.

The money you pay in is often invested in mutual funds, with the expectation that the sum you've invested will grow over time.

Benefits of variable annuities

Here are some of the appealing features of variable annuities:

• Tax-deferral. Money in a variable annuity grows without being taxed. It's taxed later when you withdraw funds.  
• Income for many years. You may opt to be paid until you pass away, and that can help you not run out of money in retirement.  
• A "death benefit." Some variable annuities will let you choose a beneficiary to receive a certain sum should you die before you receive all guaranteed payouts or if your account's balance is above a certain level. You pay for this benefit, though.
• Control. Variable annuities can give you more control than fixed annuities, letting you choose how the money in your account is invested -- conservatively or aggressively or somewhere in between. This isn't a good thing for everyone, though, especially if you're not a savvy investor. If your choices turn out well, you can end up with bigger checks, but there are no guarantees and you're also exposed to the risk of investments underperforming, leaving you with less than you'd hoped or planned for.

Drawbacks of variable annuities

Fees represent variable annuities' biggest pitfall. A variable annuity will probably charge you fees for mortality and expense risk, along with general administrative fees.

In addition to that, the securities you invest your annuity money in, such as mutual funds, will charge fees of their own -- 1.35% is a typical fee.

These fees generally will not change a lot from year to year, but mutual fund fees have been declining over the past few decades. 

These fees add up, making many alternatives to variable annuities look better in comparison.

The above-average fees, for example, which exclude extra fees such as a death benefit, total 2.85%. If you have $100,000 in a variable annuity, that would cost you $2,850 per year. If you're expecting your variable annuity to grow in value by, say, 6% annually, remember that you'll be losing 2.85% annually, too. That would shrink a 6% return to 3.15%.

A $100,000 investment will grow to $179,085 at an annual rate of 6% over a decade but will only reach $136,362 growing at 3.15% -- fully $42,723 less!

The Securities and Exchange Commission has warned, "For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity."

Indexed annuities

Sometimes called "fixed indexed annuities" or "equity-indexed annuities," indexed annuities are linked to the performance of an index, such as the S&P 500 stock index.

You could invest in the S&P 500 easily via a low-fee index mutual fund such as the Vanguard Index 500 (VFINX) or via an ETF, such as the SPDR S&P 500 ETF (SPY).

But if you invest in an S&P 500 index fund and the S&P 500 dips or plunges, so will your investment -- though over long periods, it has always recovered and gone on to new heights. That volatility scares some people, so they're happy to hear about indexed annuities, which often promise no chance of losing money or a guaranteed minimum return.

Those promises come at a cost, though. If you read the fine print on indexed annuities -- as you always should before investing in one -- you'll see that while your downside is indeed limited, so is your upside. Your gains are constrained in a variety of ways.

For starters, there's the "participation rate," which measures what portion of the underlying index's return you might receive in your investment's return. Imagine that the S&P 500 was the benchmark, for instance, and it gained 10% in a year. If your participation rate was 100%, the participation component of your investment's return would be 10%. If it were 80%, you'd be credited with 8%.

That might seem pretty good, considering that you're promised little or no losses in the investment. But wait -- there's a cap, a strict limit on how much you can earn. If the cap is, say, 7%, then even in a year when the S&P 500 surges 20% or 30%, you'll earn no more than 7%. The news gets worse, too. There often are annual fees that can be subtracted from the return, and they can make quite a difference.

The folks at Fidelity crunched some numbers to show how performance limiting indexed annuities can be. They point out, for example, that in 2013, the S&P 500 surged about 30% (32% including dividends), while a representative indexed annuity delivered just 10%. They also looked back at the decade ending in 2013 and found that the overall S&P 500 averaged an annual gain of about 7.4%, while the annuity averaged 3.2%.

That's a hugely meaningful difference. A $10,000 investment that grows for a decade at 7.4% will become $20,400, but if it grows at 3.2%, it will only become $13,700.

Alternatives to annuities

There are other ways to set up income streams for yourself. For example, you can generate annuity-like income from a portfolio of bonds that pay interest and/or stocks that pay dividends. Many healthy stocks sport dividend yields of 3%, 4%, 5%, and more. Even a simple, broad-market index fund will sport a dividend payout.

If you have a $300,000 stock portfolio with an average dividend yield of 4%, it will deliver $12,000 to you each year, which would be $1,000 per month. Better still, healthy and growing companies tend to increase their payouts over time so your income will offer some inflation protection. 

Social Security is another retirement income source to plan for, and it's essentially an annuity, too. Instead of paying an insurer a lump sum for monthly checks in retirement, you pay taxes into the system throughout your working life and receive monthly checks in retirement.

The average monthly retirement benefit check was $1,461 in early 2019.

The average payment does go up over time, but not very quickly.

Clearly, no one will be living lavishly on this income, but there are a bunch of ways to increase your Social Security benefits.

How to buy an annuity

Here are some last things to know before you decide to buy any annuities:

• Shop around on your own. You don't have to wait to be approached by an annuity salesperson who may be getting a commission by selling you one -- especially since such brokers may be ripping you off. Your existing online brokerage might even offer annuities.
• Only buy from highly rated insurers. Annuity income is not 100% guaranteed. The financial company you've contracted with does promise to pay you according to the terms of the contract, but that promise is only as reliable as the company that sells it. Thus, seek out the best-rated insurers and financial-services companies, and perhaps divide your purchase money between a few of them. For example, if you were going to spend $300,000 on annuities, you might buy a $100,000 contract from three different highly rated insurers.
• Understand what an insurer's credit ratings mean. A big insurance company might have several subsidiaries, each with its own credit rating. Be sure to find and assess the rating for the entity that will be issuing your annuity. This table can help you make sense of the top ratings from the major agencies:

AGENCY	TOP RATING	SECOND BEST	THIRD BEST
A. M. BEST	A++	A+	A
Fitch	AAA	AA+	AA
Standard & Poor's	AAA	AA+	AA
Moody's	Aaa	Aa1	Aa2

Source: Securian.com.  

• Take the interest-rate environment into account. Annuities tend to offer smaller payments when prevailing interest rates are low. It can be worth delaying buying any annuities until rates rise. If you think rates are going to rise and you can afford to wait one or a few years before buying an annuity, you may end up receiving fatter checks each month. After all, in addition to interest rates possibly being higher, you'll also be older when you buy, which will result in higher quotes. You might also consider using the "laddering" strategy, where you divide your total planned annuity purchase into chunks and buy installments over time. For example, you'd buy a third of the annuity income you want now, another third in a few years when rates may be higher, and the last third even later.
• Plan with your spouse. You can get a joint fixed annuity that pays until both you and your spouse have passed away. It will pay less than you'd get if you spent the purchase price on two annuities, one for each of you, but when one of you dies, any solely owned annuity dies, too. With a joint annuity, the surviving spouse will continue to receive that same joint-annuity check.
• Plan for inflation. If you're willing to pay a little more or receive a little less, you might be able to have your annuity payouts adjusted for inflation. That can be well worth it if you're expecting annuity income for many years.
• Minimize fees. Find out what fees you'll face, including "surrender" charges if you want to take money out of the account early.

Is an annuity right for you?

If you could use reliable income in retirement, you should at least consider annuities as part of your retirement plan, ideally focusing on fixed annuities over variable or indexed ones.

The best annuities can provide needed funds for the rest of your life on terms that you choose.

Annuities aren't great for everyone, though. If you already have sufficient income streams set up for yourself, you don't necessarily need another one.

After all, if you spend a big chunk of money on an annuity that will pay you for the rest of your life, but then you die after just a few years, all that money will be gone, and your loved ones can't inherit it. 

Read more about annuities, and perhaps consult a trusted advisor, as you determine whether these investments work for you.