Is an Annuity the Best Choice for You?

The two biggest risks retirees face as they save throughout their lives are outliving their money or losing it all in the stock market prior to needing it. Annuities can help hedge those risks, allowing investors to contribute a lump sum with the promise of guaranteed payments for the rest of their lives.

A "contract with an insurance company," annuity products can be wide-ranging to fit the needs of the individual, says Patrick Stark, director of financial planning for R.S. Crum, a Newport Beach, California, wealth management firm.

"They are essentially a private pension," says Dan Thompson, a financial advisor and founder of Wise Money Tools. "Since pensions have become all but extinct, replaced by the 401(k), there can be a gap in retirement income for many retirees."

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Annuity payments can be fixed, variable, or tied to an investment index, and can be immediate or deferred. The beneficiary can be one or more individuals and can be passed to heirs. Some annuities are designed for income while others are designed for growth, Thompson says.

Because of this complexity and tailored approach, most financial experts advise prospective annuity purchasers to heed the following tips.

Know what you're buying, and from whom. An annuity's "guaranteed payments" are subject to the claims-paying ability of the insurance company so if the insurer goes bankrupt, "your payments are at risk," Stark says. There's the possibility that state guaranty associations could intervene, but you may not get full coverage, and it may take several years for the bankruptcy process to play out.

"Financial strength of the insurer should be a top consideration in deciding which company to do business with," Stark says. "Firms such as A.M. Best, Fitch, Moody's, and Standard & Poor's publish financial strength ratings of insurance companies."

Some annuities may also have high expense ratios and pay high commissions to the financial advisors who sell them, Stark says. An exception may be a fixed immediate annuity, which is also much easier to understand, he says. A fixed immediate annuity would begin payments now rather than a deferred annuity that would make payments beginning later. You can take a fixed payback period, a fixed amount or a combination of recipients, such as you and your spouse.

Investors may also want to consider a product like a single premium immediate annuity, or SPIA, which pays about 5 to 7 percent annually, says John Barnes, a certified financial planner and operator of TheAnnuityAssistant.com, an online annuity brokerage.

"Contrast this with the well-known 4 percent withdrawal rule of thumb, which says that a retiree can safely withdraw 4 percent each year from an investment portfolio and not worry about outliving the funds," Barnes says.

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Invest a lump sum only if you won't need it back that way. Once you invest a large amount into an annuity, the only way to get it back is through the annuity income schedule, Thompson says, so think very carefully about the decision before signing on the dotted line.

Consequently, people who don't have much cash should avoid annuities, Barnes says, recommending those who opt for them have at least $250,000 in their retirement portfolio. There should be enough discretionary cash for emergencies and unexpected illnesses or bills.

But for those with the cash reserves, annuities can be a way to ensure some of your income is protected against market forces or unexpected life events, since you can design it to cover 100 percent of your fixed expenses, Thompson says, or use it to obtain freedom to enjoy activities in retirement, knowing there is a check coming the following month.

And if you think you'll need a large amount of cash before age 59.5, don't buy an annuity just yet. The same penalties apply to early annuity withdrawals as for retirement plans like a 401(k), Thompson says.

It's possible to pass annuities to an estate. If your goal is to give your money away quickly, it's best to leave it alone, Thompson says. But many annuity holders never take the income. Instead, they pass it to an estate, "as they are free of probate, and pass easily to heirs with no risk of loss," Thompson says.

Because annuities are designed to preserve income, you can't expect to make high returns associated with riskier investments, Thompson says. That's part of the reason why you'll want to diversify so that annuities are about 20 to 50 percent of income-generating retirement assets.

The exact amount and type of annuity product you buy -- if it's right for you at all -- will always be largely determined by your needs and goals. Potential annuity purchasers should examine the risks, fees, commissions and terms of each annuity option available to them.

"The risk all retirees face is what is called longevity risk, which is outliving their money," Thompson says. "An annuity can assure that running out of money cannot happen in their lifetime."

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But they can also be "a disaster if you don't match them up correctly to your needs or they don't make sense for a situation."

Kayleigh Kulp is a freelance journalist who also writes or has written for CNBC, The Daily Beast, Afar, the Washington Post, Travel Channel, Travel + Leisure, CNN, Fox Business Network, Wine Enthusiast, The Daily Meal, Los Angeles Times, Bust, AARP and AAA Journey magazines, ABC News, Miami Herald, San Antonio Express-News, Washington Examiner and The Baltimore Sun.