Annuities: A Good or Bad Investment?

What is an Annuity?

As we prepare for retirement, our focus naturally shifts from accumulating assets to figuring out how to use them to generate a predictable stream of income that can replace our paycheck. One financial tool that can be utilized for this purpose is an annuity. An annuity is a contract between you and an insurance company in which you make a lump sum payment (or series of payments over time) and, in return, receive regular distributions for life or some other agreed-upon period. In this article, we’ll take a closer look at the different types of annuities, explain how they work, and assess their pros and cons.

Key Points

• Military service members sometimes have lifelong benefits that need to be taken into account when considering an annuity.
• Annuities offer some compelling benefits for investors, like guaranteed lifetime income, protection from market downturns and tax deferral.
• Because of these unique features, annuities sometimes have surrender charges and fees that can impact your returns and require you to give up control of your money.
• A knowledgeable financial advisor can help you decide whether an annuity is the right fit, what type of annuity makes the most sense, and even review alternative investment opportunities.

Understanding Military-Specific Retirement Income Sources

Military members who served for at least 20 years and are retiring under the Blended Retirement System (BRS), as well as the High-3 Retirement System, earned a guaranteed, lifelong pension, among other benefits. This pension functions much the same as an annuity, in which guaranteed payments are made to you for the rest of your life or your spouse’s life, should you opt for the Survivor Benefit Plan (SBP). Those receiving military retirement income may have less need for the additional guaranteed income provided by an annuity. But that depends on your specific financial circumstances and your comfort with fluctuations in the value of your investments. A knowledgeable financial advisor can help you determine if an annuity is right for you.

Another potential source of guaranteed income for military families is SBP, which ensures that a portion of a service member’s retirement pay will continue to be paid to their beneficiaries after their death. This protection is paid directly from the service member’s retirement pay and will replace up to 55 percent of that lost income.  

A substantial benefit of military service and participation in the BRS is the opportunity to accumulate assets for retirement in the Thrift Savings Plan (TSP). Like a 401(k) at a private company, your TSP can grow through a combination of personal contributions, government matching contributions, automatic government contributions, and investment returns. And upon leaving the military, separating or retiring service members have the option of converting their TSP into an annuity.

Finally, some veterans may also receive payments due to service-related injuries. The mechanisms through which you may receive these benefits is unique to each servicemember and the nature of their injuries or disability rating. The important point to consider is the same, however—these payments functions similar to that of an annuity. 

The Advantages of Annuities—Why Should I Consider One?

Long-term Guaranteed Income

One of the principal attractions of annuities is their ability to deliver guaranteed income for life – or for a specified period of time. Particularly in the case of fixed annuities, investors are insulated from the volatility that typically accompanies equity and even fixed-income investments like stocks, bonds and mutual funds.

Different Annuities for Different Circumstances

A wide array of annuities capable of meeting diverse needs are available in the marketplace. Distributions can begin immediately or in the future, returns can be fixed or variable, and there are different return and fee structures. Annuities can also be customized by contract add-ons known as riders. These add-ons can, for instance, continue regular payments to a spouse or dependent after your death or protect you from losses in market downturns. The important thing to understand is that these various bells and whistles are not free, and you should always understand how their cost could potentially impact your results.

Guaranteed Positive Returns and Protection from Market Volatility

For risk-adverse investors who need enough growth to keep pace with inflation but may be squeamish about the idea of their portfolio losing value during retirement, certain annuities can offer some protection from market downturns in exchange for limiting upside gains.

Fixed annuities come with, as the name suggests, fixed interest rates, so market downturns are not passed on to you as the annuitant. Variable annuities can allow you to participate in limited market gains while also offering some protection from the volatility associated with full participation in financial markets.

Tax Benefits

Annuities also come with tax benefits. Given their lack of liquidity compared with other investments, funds within an annuity grow tax-deferred, though the money is taxable as ordinary income when withdrawn. As with an IRA or 401(k), being able to defer paying taxes can allow your money to compound more quickly.

The Drawbacks of Annuities—What Factors Should I Consider?

Complicated Contracts

It’s no secret that voluminous contracts loaded with legalese and technical jargon can be confusing—and that is what you may encounter with some annuities. Some companies have streamlined their annuity contracts, yet others are still complex. Their intricacies can be confusing, opening you up to fees and penalties you may not have fully understood prior to signing the contract.

Annuity Fees Can Be Punishing

One often-cited drawback to annuities is higher fees than most other investments. But that typically depends on the type of annuity. Because of their simple structure, fixed annuities tend to have lower fees, though most include “surrender charges” if money is withdrawn or the contract is terminated prior to a specified time period. Variable annuities include underlying investments that offer the potential for higher returns, but because they include investment management fees and charge other fees for various features and riders, the cost to own them can be significantly higher than for many other investments. It’s important to fully understand all of the fees that may apply to an annuity you are considering purchasing because they have the potential to significantly impact your total returns.

More Restricted Access to Your Money

In exchange for the guaranteed income that annuities offer, you will likely have more limited access to your money. With an immediate, fixed annuity, for example, you exchange a lump sum for guaranteed income, foregoing the opportunity for potential growth and the opportunity to leave an inheritance to your family. And because of tax advantages that mirror those of traditional IRAs, 401(k)s and the TSP, a 10 percent penalty is charged on any funds withdrawn prior to age 59 ½. Finally, as mentioned previously, surrender charges often apply to money that is withdrawn prior to a time period specified in the annuity contract, typically five to seven years.

Are Annuities a Good Investment for Military Service Members?

So, are annuities a good investment for a military servicemember or veteran? As with many financial planning questions, the best answer is: It depends. As we’ve established, the most unique feature of an annuity is its ability to deliver guaranteed income that can help replace your paycheck when you retire. So the question becomes: How much guaranteed income do you want or need in retirement, and what other sources of guaranteed income will be available to you?

The answer to the first question – how much guaranteed income do you want or need? – likely depends on your risk comfort level and how that influences your overall retirement income plan. Those less comfortable with risk typically want more of their retirement income to be guaranteed; those more comfortable with risk are normally interested in allocating a larger portion of their portfolio to investments with higher growth potential whose value fluctuates – like stocks, bonds and mutual funds.

The answer to the second question – what other sources of guaranteed income will be available to you? – varies significantly among veterans approaching retirement. You may have military retirement income (your pension), a military disability retirement annuity, income from your TSP account and Social Security. Or you may have only Social Security. If you’re in the former camp, it’s less likely that you need a commercial annuity. If you’re in the latter group, adding an annuity to your retirement income probably makes more sense.

But even if Social Security is the only form of guaranteed income you know you will be able to count on in retirement, that doesn’t necessarily mean an annuity is the right fit for you. There are several other considerations that have been addressed in this article – like potentially higher fees and restricted access to your money – that must still be carefully weighed.

A Financial Advisor Can Help

As with most financial planning choices, making a decision about whether to purchase an annuity is best made within the context of a discussion about your full financial picture. A knowledgeable financial advisor will take the time to clearly understand your circumstances (including all of your military benefits), goals and risk comfort level in order to help you decide:

1. If an annuity is the right fit for you
2. What type of annuity is most appropriate
3. Whether there are better alternatives

Once those decisions have been made, your advisor can work with you to build a comprehensive income plan to fund the retirement you envision. Get started with a First Command Financial Advisor.

Guarantee depends on the claims-paying ability of the issuing insurance company and does not apply to the investment return or principal value of the separate account. Before buying an annuity, you should find out about the particular annuity you are considering. Request a prospectus from your Financial Advisor and read it carefully. The prospectus contains important information about the annuity contract, including fees and charges, investment options, death benefits and annuity payment options.

TSP funds have very low administrative and investment expenses, and low expenses can have a positive effect on the rate of return of your investment. Prior to requesting a rollover from your Thrift Savings Plan (TSP) account to an Individual Retirement Account (IRA), you should consider whether the rollover is suitable for you. There may be important differences in features, costs, services, withdrawal options and other important aspects between your TSP account and IRA.

Diversification, asset allocation and portfolio rebalancing do not guarantee a profit or protect against a loss in a declining market. They are methods used to help manage risk. Investment returns and principal value will fluctuate and your investment, when redeemed, may be worth more or less than its original cost. Sales charges and taxes may apply.

First Command does not provide legal or tax advice, and this article does not contain any legal or tax advice. Any recommendations provided to you in this article are strictly for financial planning purposes only. Should you require legal or tax advice, you should consult with your attorney or tax advisor.