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As economic uncertainty looms, more seniors and soon-to-be retirees find themselves searching for ways to throughout their retirement years. With , questions swirling around when the Federal Reserve might cut interest rates and , having a guaranteed source of retirement income has become increasingly important, and the appeal of in this regard is undeniable.
When you , you typically pay a lump sum to an insurance company in return for regular monthly payments that last throughout your lifetime. But not all annuity purchases are created equal, especially in today's complex interest rate environment, which has created both opportunities and traps in the annuity market. And, the difference between and often comes down to understanding a handful of fundamental rules.
These rules act as practical guidelines, and understanding them before committing your money to an annuity this August could be the difference between a comfortable retirement and a major (and prolonged) financial headache.
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Before you put your hard-earned money into an annuity, make sure you understand the following rules:
Any annuity with should raise red flags — unless it provides exceptional guarantees or features you can't get elsewhere. This includes management fees, mortality and expense charges, administrative costs and rider fees combined.
Simple immediate annuities often have no ongoing fees, while low-cost deferred annuities typically keep total costs well under 1%, so both can be good options to consider now. However, many variable and indexed annuities pile on costs that push total fees to 3% or higher annually. At those fee levels, the insurance company is taking such a large cut that your money may have little chance to meaningfully grow.
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Another rule worth noting is the 10-year rule, which states that you should never purchase a deferred annuity unless you're confident you won't need the money for at least 10 years. That's because historical data shows that deferred annuities may not outperform low-cost index funds over periods shorter than 10 years. And, if you withdraw funds from a deferred annuity before the 10-year point, there may be , too.
So, if you're going to buy a deferred annuity, you need to give the tax-deferred growth enough time to overcome the higher fees and limited investment options that come with them. If you're within 10 years of needing the income, you may want to consider immediate annuities instead, as these types of annuities start paying right away and avoid the growth period entirely.
Before considering any annuity purchase, calculate your essential monthly expenses, including your housing, utilities, food, healthcare, insurance and minimum debt payments. The income floor rule states that these non-negotiable costs should be covered entirely by guaranteed income sources: .
This approach tells you exactly how much annuity income you actually need, preventing both over-purchasing and under-purchasing decisions. Only after you've secured this income floor should you invest remaining assets in stocks, bonds, or other growth-oriented investments.
Regardless of how attractive an annuity appears, financial planners generally recommend limiting your total annuity allocation to no more than 25% of your retirement portfolio. This rule prevents over-concentration in illiquid products while still allowing annuities to play their intended role as portfolio stabilizers.
For example, if you have $1 million in retirement assets, this rule dictates that you should keep your annuity investments below $250,000. This maintains diversification and ensures you have the flexibility to adapt your strategy as circumstances change over time.
refers to a way to evaluate whether an annuity's guaranteed income stream is equal to (or better than) what you might safely withdraw from a traditional portfolio using the 4% rule. For example, if you have $500,000 in retirement savings, the traditional 4% rule suggests you could safely withdraw $20,000 in the first year. If an immediate annuity offers you $25,000 annually for life, that 5% payout rate appears more attractive.
However, it's important to remember that annuity payments usually don't adjust for inflation unless you opt for that feature, while the 4% rule assumes annual inflation adjustments. So, use 4% as your baseline comparison, but factor in longevity protection, inflation adjustments and liquidity trade-offs when making your decision.
Annuities can be valuable tools for retirement planning, but they require careful consideration of your specific circumstances and goals. While you shouldn't let the complexity of the annuity market intimidate you, you don't want to oversimplify your decision either. Take time to understand any annuity you're considering, compare it to alternatives and ensure it aligns with your timeline and liquidity needs. The right annuity purchased at the right time can provide decades of financial security, but the wrong one can lock up your money in an underperforming investment that you'll ultimately regret.
