Annuities: How they work, and what to consider before purchasing one
There are different types of annuities, but in a nutshell, here’s how an annuity works: You give the annuity provider a large lump sum, say $150,000, of your retirement savings. The annuity company takes total control over this lump sum of money and, in exchange, offers you a contract guaranteeing that you will be paid a set amount every month when you retire.
The annuity company pools your money with that of other annuity holders and places it in long-term investments designed to ensure the company’s ability to pay out the monthly sums guaranteed to all eligible annuity holders.
The allure is that you will receive a stable, reliable income in retirement. But there are several catches.
- High fees. Annuity companies tend to charge very high fees (3%-4%) on your money while it’s invested with them. These fees are often hidden or applied in ways that are difficult to decipher on a statement.
- It’s difficult to withdraw your money. Let’s say you become dissatisfied with these high fees and want to get your money back to invest elsewhere. Because your money is tied up in long-term, communal investments that the annuity company relies on, they are extremely reluctant to let you take your money back. In fact, they will usually charge you an expensive “surrender fee” if you withdraw your money (between 10% and 15% of your total invested balance).
- They’re not insured. That means if the annuity company goes broke, you can be left empty-handed, with no way to reclaim your money.
The complexity and risk associated with annuities means you should consider all of your options and before moving forward with one. If you do decide to purchase an annuity, it might be a good idea to keep a portion of your retirement savings in a traditional retirement account like your 401k or an IRA.