Annuities: Advantages and Disadvantages
The promises of an annuity are appealing: Annuities can provide guarantees such as a stream of income that lasts for your entire life, potential tax deferral, and other features. But it’s important to understand both the advantages and disadvantages of an annuity before putting your money into one. A bit of study can help you end up with exactly what you need—and avoid getting tangled up in the wrong product.
An annuity is an insurance contract. Using an annuity often looks and feels like using an account that you put money into, whether you invest a lump sum or you make monthly contributions to your account. Depending on the specifics of your annuity contract, your insurer might promise to pay you monthly income (whether that starts immediately or in the future) or grow your savings over time.
Buying an annuity can tie your money up, possibly for the rest of your life. Be sure you have a clear understanding of what you’re getting into—and how much it will cost to get out—before you consider an annuity.
Advantages of Annuities
Every annuity contract is different, so the specific benefits depend on which insurance company you buy from, which optional features you select, and how you ultimately decide to use your annuity.
One of the most appealing features of an annuity might be the ability to receive income payments for life. To do so, you invest money in an annuity and instruct the insurer to pay you monthly, quarterly, or annually. No matter how long you live, those payments should continue if you choose lifetime payments. Those payments can potentially replace the income you earned in your working years, and monthly payments may feel similar to monthly wages in your working years.
If you die shortly after beginning payments, the insurer might be able to keep all of your money. If that concerns you, explore options such as joint lifetime payments or options with beneficiaries. For example, a “10-year period certain” option keeps making payments for the greater of 10 years or your life (other options are available).
To get the biggest monthly payments, you need to take some risk. When you choose a single lifetime income payout (with no payments to beneficiaries), insurance companies typically offer the highest monthly payments. If you add a period certain or joint annuitant, the insurer typically reduces the payment because you’re taking less risk.
Any growth, income, or interest inside of an annuity contract is typically tax-deferred. In other words, you may not need to report that income to the IRS each year. Instead, you pay taxes when you withdraw funds.
That feature is often considered a selling point, but it may not be as advantageous as you think. If your money is already in a tax-deferred account (such as an IRA, 401(k), or 403(b) plan), you don’t get any additional benefit from the tax deferral in an annuity.
If you happen to be in a particularly high income tax bracket, you could potentially benefit from using an annuity. However, it’s crucial to analyze the numbers instead of just buying into the concept of tax deferral. For example, you might come out ahead in taxable accounts, depending on the specific nature of the gains you expect to receive (and other items on your tax return). Plus, withdrawing funds from an annuity can potentially lead to income taxes and additional penalty taxes.
Annuities may provide a guaranteed return on your investment. For example, fixed annuities have a stated interest rate, and the insurance company pays you that amount annually. The amount may change over time, or you may receive a set rate for several years.
Some annuities also offer guaranteed “hypothetical” growth. In those cases, your account balance doesn’t necessarily grow—instead, a hypothetical account balance increases, from which you can take income later. Even if your actual account balance decreases (or goes to zero), you may potentially be able to draw income.
With those contracts, the guarantee is most valuable if you keep your money with the insurance company for the rest of your life (so you need to be certain you’re in it for the long term). If you decide to walk away, you won’t necessarily be able to cash out the hypothetical account. Your actual account value, which may be less than the hypothetical income base, is what you can take with you.
Any annuity guarantees are only as strong as the insurance company making the guarantee. If the insurance company experiences financial hardship, your savings, earnings, or income could be at risk. Choose only the strongest insurance companies, and avoid putting all your eggs in one basket.
Limited (or No) Losses
Annuities like equity-index annuities may promise that you can’t lose money in the stock market. They promise to provide some exposure to market increases with limited downside risk (or no risk of loss). If that sounds too good to be true, you’ll want to find out what the tradeoffs are. Ultimately, for a conservative investor, these products could make sense. But there are other alternatives for conservative investors that are less complicated and that do not tie up your money with steep surrender charges. Be sure to explore all of your options before you commit to anything.
Disadvantages of Annuities
You’ve heard the promises and read the glossy sales literature, but what else might be important to know? We’ve touched on some of these topics above, and some of the key disadvantages are summarized below.
Potentially High Fees
Annuities have features that cost money. Adding optional riders can increase the cost. When you add up the cost of underlying contract charges, riders, and investments inside of an annuity, the all-in charges can be quite high. Be sure that it makes sense to pay for everything you’re buying.
Investing in an annuity may require a long-term commitment. If you want to cash out (if you change your mind or need money), it could cost you. Annuities typically offset the commissions they pay to sales agents with surrender charges, which are fees you pay to withdraw money during the early years of your contract. Those charges may last 10 years or more, and a lot can happen in that time. You can often withdraw 10% of your initial premium each year, and withdrawals for certain healthcare expenses or required minimum distributions might be allowed without additional fees.
Withdrawals from an annuity contract may result in taxes, penalties, and other complications on your tax return. Plus, annuity withdrawals are typically treated as ordinary income, which may be taxed at a relatively high rate. If you could get long-term capital gains treatment on your investments instead, that might be beneficial. Review any annuity strategy with a CPA who is familiar with your tax return before you invest in an annuity.
Most insurance agents are ethical professionals who want the best for their clients. But annuities, in particular, offer fertile ground for abuse. Annuities pay relatively high commissions, and salespeople do not necessarily need securities licenses or rigorous oversight to sell these products. Plus, the fees and commissions are often invisible. Meanwhile, agents might not tell you how much they’re earning or what tradeoffs you face when purchasing a high-commission product.
It may be possible to mitigate some of the pitfalls of buying an annuity. Immediate lifetime income annuities are relatively straightforward with low commissions, and fee-only annuities do not pay the high commissions that traditional annuities feature.
Annuity Terms to Know
Learning about annuities can feel like learning a new language. Get familiar with the concepts below, which should help you research which insurance companies and annuities are right for you:
- Contract Owner
- Surrender Period
- Variable Annuity
- Equity-indexed annuity
- Longevity annuity
- Immediate vs. Deferred Annuities
- Lifetime payment options
There are multiple types of annuities, so this page covers the advantages and disadvantages at a high level. For a complete analysis, it’s critical to drill down into the details of each product offering and insurance company, as well.