written by: Winston Smith•edited by: John Garger•updated: 5/21/2011
The promise of an annuity is simple - put in a set amount of money and receive a stream of payments until you die. However, there are downsides to this type of investment such as a lack of flexibility if your financial needs change.
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Second only to buying a house, retirement planning is one of the most complex and challenging financial goals we face. There are many different factors to consider such as estimating how much income you want and need in retirement, deciding whether or not you wish to leave an estate, and deciding where you want to live.
Purchasing an annuity is one way to increase the predictability and reliability of retirement income. The basic idea of an annuity is simple: you provide a set amount of capital (e.g. $100,000) and in return the annuity company promises to pay you a stream of income for a set period (e.g. 10 years, 15 years, or longer). An indexed annuity means that your annuity payments increase with the rate of inflation.
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Depending on your financial situation, 401(k) accounts and other savings, an annuity can be a helpful complement to the rest of your financial portfolio. There are many types of annuities depending on how much capital you have and what you want from the annuity, ech with its own set of advantages including:
Predictability: The primary advantage of an annuity is the predictable stream of income you receive from it. In most cases, an annuity pays you a monthly benefit.
Passive Investment: Once you purchase an annuity, there is little need to continue monitoring the investment. Unlike a stock portfolio, you do not need to worry about the daily movements of the stock market. You do, however, need to worry about the financial health of the company that runs the annuity.
Minimize Inflation Risk: With an indexed annuity, your payments increase in pace with inflation. For example, if inflation increases 2%, then your annuity payments increase 2% as well. It is important to understand that some goods and services such as health insurance and gasoline increase in price much faster than the general inflation rate.
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The advantages of an annuity sound attractive, but this type of financial product retains some disadvantages. These negative points can best be understood by contrasting annuities with other types of investments.
Concentration: If you hold a portfolio of twenty established stocks that have a long history of paying dividends (e.g. Coca Cola, AT&T, etc.) in a variety of industries, your investments continue to provide income even if one industry suffers. With an annuity, you generally depend on a single company to stay in business and deliver on its promises.
Passive: The passive nature of annuities means that it can be difficult to understand how the annuity works. Some annuities only focus on highly reliable government bonds while other annuities rely on higher risk investments. Understanding where your annuity income comes from is challenging and this makes some investors nervous.
Inflexible: Imagine that you are five years into your retirement and your annuity income has been satisfactory so far. At age 70, your children have a health crisis and call on you for additional support. If you have a portfolio of stocks, bonds, mutual funds and ETFs, you have the option of selling or transferring some assets to respond to the crisis. In most cases, an annuity cannot be changed or it can only be changed with penalties.
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Resources and References
To learn more about annuities and other tools that can be used to provide income in retirement, explore the resources outlined in this section.