Conventional wisdom says that the sooner you start saving and planning for retirement, the better. And that totally makes sense. Thanks to compound interest, the earlier you start stashing away money, the easier it will be to build a stronger and more studier nest egg for retirement. And, if you experience a financial setback, you have more time to bounce back. Annuities are one way to accomplish your goals.
Additionally, if you start saving when you’re younger, it doesn’t cost as much upfront. For example, a survey from Charles Schwab found that the magic retirement number is $1.7 million. If you aim to reach that goal and you’re 25, here’s what you would have to put aside depending on the rate of return;
- $1,433.51 per month with a 4% return
- $853.63 per month with a 6% return
- $486.97 per month with an 8% return
If you wait another five years, that will come out to;
- $1,860.50 per month with a 4% return
- $1,193 per month with a 6% return
- $741.10 per month with an 8% return
And that will continue to increase as you get older. There isn’t a one-size-fits-all number when it comes to the amount you should save for retirement. Instead, factors like your income, planned retirement age, and the lifestyle you want to live will influence this figure.
Retirement? Why bother?
On the flip side, others argue that you’re better off waiting until you’re older. One reason is during your 20’s; you should focus on paying down debt. Another argument is that there’s more to life than saving.
According to a working paper from the National Bureau of Economic Research (NBER), the authors argue that young people should wait until their 40’s to save for retirement. The reasons being that over-saving for retirement sacrifices short-term goals, and life is just too short and unpredictable.
There’s also a lot of cynicism about the future that makes saving for your retirement when in your 20’s seem pointless. And, that seems valid considering the bleak outlook of the future. At the minimum, this includes a potentially depleted Social Security fund, turbulent economies, and how issues like climate change will influence the quality of life.
But maybe an annuity can help solve this retirement quagmire.
Let’s talk annuities.
For the last several years, annuity companies have made an effort to attract younger investors. For example, New York Life’s Guaranteed Future Income annuity dropped its initial investment of $10,000 to $5,000 to make it more affordable for younger generations.
Moreover, companies like Due are revolutionizing annuities as it makes the product accessible to everyone. This is through straightforward retirement planning and the ability to purchase your own account without an agent. In fact, it only takes five minutes to set up your account. And, you control how much money you want to contribute.
Additionally, increased public awareness, economic conditions, and perks like a guaranteed lifetime income and tax-deferred growth have made annuities in demand. But, what exactly is an annuity?
An annuity is a retirement vehicle like IRAs, 401(k)s, stocks, bonds, mutual funds, and savings accounts. What makes them unique, however, is that annuities are long-term investments that an insurance company backs. As such, this guarantees to pay out a fixed stream of payments to an individual.
The different types of annuities.
Additionally, annuities are tax-deferred. And, they can be purchased by anyone who is looking for a pension-like retirement income. But, annuities can also be complex as they come in different types.
- Fixed annuities are similar to savings accounts. You deposit money into an account and earn interest. With a Due fixed annuity, you’ll get 3% on every dollar deposited. This provides a safe and predictable income. On the flip side, it doesn’t earn as much as other investment products.
- Variable annuities are more closely related to mutual funds. That means you choose from a series of investments that dictate the value of the annuity. This makes variable annuities riskier than their fixed counterparts. But, it can provide more growth opportunities.
- Equity indexed annuities are a hybrid of fixed and variable annuities. Your principal is protected, but gains are limited.
Furthermore, annuities can be either deferred or immediate. With deferred annuities, you either purchase an annuity with a lump sum or series of smaller payments. In return, you’ll receive regular payments sometime in the future, like 20 years from now. With immediate annuities, you purchase it with one lump sum and can make withdrawals, well, immediately.
Why young investors should consider an annuity.
With the basics out of the way, let’s go over the reason why you might want to buy an annuity if you’re in your 20’s.
Your retirement savings aren’t exposed to market fluctuations.
As previously stated, it’s commonly agreed upon that younger investors are better suited to withstand market losses. This is because they have more time to recoup any losses before retirement. In that vein, it’s tempting for younger investors to pay the stock market since they’re able to snag higher potential returns despite the risk involved.
If you’re advantageous, this might make you sweep left on a guaranteed, fixed-interest product like an annuity. But, keep in mind that already in the 21st Century, we’ve experienced multiple financial crises. So, let’s say that your portfolio’s value plummeted 25 percent in one year. To get back to your initial investment, it will have to experience an increase of 33 percent, which could take years to achieve.
While not the most exciting investments, both fixed and indexed annuities provide guaranteed interest rates. And, more importantly, you’re never putting the principal at risk of market losses.
There aren’t contribution limits.
One of the biggest knocks against tax-qualified retirement plans is that there are contribution limits. That means there’s a cap on what you can deposit into these accounts annually. For 2020, the contribution limit on 401(k)s is $19,500 a year and $6,000 for IRAs. However, if you’re over the age of 50, there are additional catch-up contributions — $6,500 for 401(k)s and $7,000 for IRAs.
With annuities, there is no such cap. As such, you can contribute however much you want annually.
You would rather pay tax on the “seed” instead of the “crop.”
Financial experts use an analogy to explain how taxes work regarding retirement plans. Let’s say that you have a bucket of tomato seeds. It would make sense to pay taxes on the seeds before they’re planted because the crop yield will be worth more than seeds. So, if you want to pay taxes on fully grown tomatoes, it will be significantly higher.
How does that relate to retirement taxes? With a 401(k) or IRA, you may get a tax break from the tomato seeds you planted. However, you must pay taxes on the entire crop.
That’s not the case with annuities. So, while you won’t get any tax savings on your annuity contributions (the seed), taxes are on the crop will be lower. Why? Because you’re only taxed on the gains between principal and income. And, you will pay for these once you take money out of the account.
Also, you’ll be placed in a lower tax bracket because your income is lower earlier in your professional life.
Some annuities allow “installment payments.”
Traditionally, if you wanted to purchase an annuity, it could only be funded by a single lump-sum payment. So, if the annuity company requires an initial premium investment of $10,000, that can be tough to come by unless you’ve fallen into some cash, like an inheritance.
Again, to convince younger investors to consider annuities, you’re able to fund the contract with multiple payments. So, instead of paying 10 grand upfront, you can contribute $1,000 a year for a decade. If you started this at 27, you would accomplish this goal by 37. And, you still have decades to keep contributing to the annuity.
Annuities are customizable.
Unlike most other retirement plans, annuities are highly customizable. This is through optional benefits known as riders. An example of this would be a death benefit that lets your beneficiaries, like your spouse or children, receive annuity payments until the funds in the annuity run dry.
Another example would be long-term care riders. This can help cover expenses if you have a medical emergency that forces you to stay in a nursing facility. It can also let you withdraw some or all of your money if you become disabled or diagnosed with a terminal illness. And, considering that long-term care is expected to double from 7 million to 14 million by 2065, it would be smart to plan for this sooner than later.
You can trust annuity companies.
I get it. I’m also skeptical of financial institutions. And, I have friends and family who are still feeling the repercussions of the 2008 recession.
With annuities, though, they are sold primarily through insurance companies. As such, they must have a life insurance license issued by their state of residence. What’s more, you can verify their financial strength through rating agencies like A.M. Best, Moody’s Fitch, and Standard & Poor’s (S&P). If the company is financially stable, you don’t have to worry about them going belly up before receiving your annuity payments.
Why young investors should avoid annuities.
While there are advantages to annuities, they’re far from perfect — especially for younger investors. Specifically, annuities may not be worth buying because of the following six reasons.
You’re buried under debt.
Unlike Boomers, Zoomers are carrying a lot of debt.
“Total personal debt in the U.S. grew from $14.08 trillion in 2019 to $14.88 trillion in 2020, a change of 6%, according to Experian consumer debt data,” writes Casey Musarra in the Santa Clara Valley Signal. “And the youngest generations contributed the most to that growth. Millennials saw an 11.5% increase in their debt from 2019 to 2020, going from an average of $78,396 to $87,448. But Gen Z’s debt—among those ages 18-23—increased even more significantly, from an average of $9,593 to $16,043, a 67.2% increase over the same time span.”
So, if you’re in your 20’s and have student loans or credit card debt, any extra money you have should be thrown towards that. This was you can minimize interest charges. Once you’re debt-free, though, you might want to circle back to annuities.
It’s better to max out other investments.
Generally speaking, you shouldn’t buy an annuity until you’ve maxed out your contributions to tax-qualified retirement plans. That’s because there’s a tax deduction for contributions with 401(k)s and IRAs. These accounts also grow on a tax-deferred basis. That means you don’t pay income taxes on contributions and earnings until you start taking withdrawals. And, unlike annuities, employer-sponsored plans often contribute matching funds.
Moreover, some long-term investments, like mutual funds and exchange-traded funds, can generate more savings and potential income.
Annuities aren’t liquid.
First, let’s dispel the myth that your money isn’t untouchable. Sure. It’s more difficult than taking money out of a savings account. But, with some annuities, you can make a withdrawal whenever you want.
The catch, and it’s a big one, is that you may have to pay a penalty for early withdrawals. In particular, if you’re under the age of 59 ½, the IRS may impose a 10 percent early withdrawal penalty tax. And that can be in addition to other steep penalties.
Let’s say that you purchased an annuity with a 10-year surrender period. In year five, you have a financial emergency and need to make a withdrawal. The annuity company may subject you to a penalty for this early access. It should be noted though most annuities do permit free withdrawals up to a certain percentage. Usually, this is 10 percent of the annuity’s value. So, if you had a $50,000 annuity, you can withdraw $5,000 annually without getting penalized.
If you believe that you need to access your money, you should first build up an emergency fund. This way, if you need to handle an unforeseen expense, you can tap into this savings account without worrying about penalty fees.
Hefty penalty fees aren’t the only cost associated with annuities. In fact, it’s not uncommon for the initial sales commission to be as high as 10% of the lump sum that you’re depositing. There are also administrative fees and management fees. And, remember how annuities can be customized? Well, that will cost you too since you have to pay for additional riders.
You won’t earn much in the current interest rate environment.
As mentioned above, fixed annuities are best suited for those who have a low-risk tolerance. In fact, most financial advisors suggest that a fixed annuity is best for an older investor who has fewer years to save for retirement. Even though the fixed annuity pays a modest rate, it’s safer than risking money in the market.
What about fixed annuities? They aren’t as risky. And they can offer a better return. Still, the upside is limited thanks to caps and spreads.
The wait can be worth it.
Imagine, if you will, that you’ve been contributing to 401(k). Even better? You’ve earned an employer match. If so, you probably have a solid amount saved for retirement.
That’s all well and good. But, it may lose its value due to market losses. To prevent that, you might want to roll the 401(k) balance over into an annuity. Besides providing you with a guaranteed income stream, your retirement funds won’t be exposed to the ebb and flow of the stock market.
The final verdict: Should you buy an annuity in your 20’s?
If you’re in your 20’s and getting serious about your retirement, the decision on whether or not you purchase an annuity depends on your financial situation and long-term goals.
To be more specific, an annuity doesn’t make sense if you’re young, have short-term financial goals, and not many liquid assets. In this scenario, a savings account is a better option in case you need to make a withdrawal because of an emergency. Remember, accessing an annuity early is pricey.
If you’re financially stable and exploring easy to diversify your retirement portfolio, you might want to look into an equity index or variable annuity. But, even if you’re in this situation, a fixed annuity still doesn’t make sense when you’re young.
And, because of the tax-free benefits and employee match, it’s not recommended to pick an annuity over a 401(k) or Roth IRA. However, if these retirement accounts are well-funded, throwing money into an annuity provides a guaranteed lifetime income that you won’t outlive. And, if there’s anything left over, you can pass it on to a beneficiary or gift it to a charity.