Wealthy investors often have access to opportunities and products that may not be available to the average person. For example, to invest in certain types of unregistered securities or private hedge funds, you may need to be an “accredited investor,” meaning you have a very high income and/or net worth.
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Annuities, on the other hand, are a fairly pedestrian type of investment that anyone can access. But certain annuity characteristics still have particular appeal to wealthier investors. Here’s a look at the pros and cons of annuities in general, along with reasons the rich often include annuities as part of their long-term wealth-building plans.
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What Is an Annuity?
Annuities are investment contracts that you can buy from an insurance company. In the simplest terms, annuities can either be immediate or deferred.
Immediate annuities convert a lump-sum investment into a stream of income that lasts for a specified period of time. Deferred annuities have an accumulation period, during which an annuity’s value can increase, and an annuitization period, at which point the value of the annuity converts into a stream of income.
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What Are the Pros of an Annuity?
No overview can cover every conceivable feature or benefit available in the annuity world. However, most annuities share these general characteristics.
Lifetime Income Stream
Probably the most popular and widely cited benefit of annuities is the opportunity to generate lifelong income. This makes sense, as one of the most common anxieties that retirees have is that they will outlive their income. Annuities remove this risk, as most contracts promise to pay a decided-upon benefit for the duration of an investor’s life, regardless of whether it lasts two years or 32 years.That type of certainty appeals to all types of investors, not just rich ones.
Note that most annuities carry other payout options in addition to the lifetime payout. For example, you may agree to receive payments for just 20 years, or you may choose to get a payout based on the joint lifetimes of both you and your spouse.
Flexible Options
Annuities have evolved tremendously over the past few decades. There are now plenty of different types of annuities, and each one has its own set of bells and whistles. This means it’s more likely that wealthy investors can find solutions tailored to their own personal financial situations.
Protected From Creditors
One big reason why annuities are on the radar of rich investors is that they are protected from various legal situations.
For example, in most cases, tax-deferred vehicles like annuities cannot be attached by creditors. This means that any money in an annuity is not subject to seizure if you are subject to a judgment, garnishment or other court order. In most cases, this includes bankruptcy proceedings, as well.
Tax-Deferred Growth
Much like an IRA or 401(k) plan, annuities offer tax-deferred growth, meaning you don’t have to pay any tax on income or gains until you withdraw them. This can be of particular interest to the wealthy. While there are limits on the amounts you can contribute to an IRA or 401(k), if you have enough income, you can sock away even more money into a tax-deferred annuity after you have maxed out your traditional retirement plans.
What Are the Cons of an Annuity?
Unfortunately, annuities in general have a number of built-in disadvantages, and some specific annuities have even more drawbacks. Here are important things to know before you invest.
High Costs and Fees
Annuities are notorious for high costs and fees. For starters, many annuities charge a steep upfront commission. According to Annuity.org, these commissions can range from 1% to 3%, for single premium immediate annuities, all the way up to 6% to 8% for fixed index annuities.
But commissions are just the start. If you buy an annuity that has an active investment component, expect to pay annual expenses of at least 0.3%, which is on top of the mortality expenses most annuities charge that run from 0.5% to 1.5% of the policy value every year.
If you’re looking to get out of your contract in the first 8-10 years after you purchase it, expect to pay a surrender fee that could start as high as 10% of your total value.
Poor Liquidity
An annuity is designed to be a long-term investment. In most cases, you’ll face high surrender charges if you want to get out before a number of years have passed. Although there are usually ways to get at least some money out of an annuity, if you’re looking to liquidate an annuity and move into bonds, for example, you’ll likely take a big hit to your principal.
Remember also that, as annuities are tax-deferred vehicles, you’ll have to pay an early withdrawal penalty of 10% if you take money out before reaching age 59 ½, just like with a traditional IRA.
Complexity
With their numerous features and benefits, payout options, fees and insurance components, annuities can be much more complex than simple stocks or bonds. As one of the cardinal rules of investing is that you shouldn’t buy something you don’t understand, you’ll have to do some legwork if you want to own an annuity.
The Bottom Line
Wealthy investors can leverage certain aspects of annuities, which is one of the reasons they are popular. For example, those with a high level of disposable income can contribute to an annuity if they have maxed out their traditional retirement plans. They’re also less likely to be concerned with the early withdrawal penalties of annuities, as they can afford to leave their investments alone for a long period of time.
But annuities can have benefits for everyday investors, as well — just be sure to understand all of the drawbacks before you decide to invest.
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This article originally appeared on GOBankingRates.com: Rich People Love Annuities — And Here’s Why
