Pros and Cons of Annuities

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An annuity is a financial product that provides a series of payments at regular intervals over a specified period of time or for the rest of a person’s life. Insurance companies or financial institutions typically offer it as a means of creating a steady income stream during retirement or for long-term financial planning for retirees. As good as that can sound, there are many pros and cons of annuities to consider.

Annuity Pros 

While annuities vary wildly in terms of their benefits, most annuity products offer at least one, if not more, of the following pros.

1. Stable Income

One of the highlights of an annuity is that it can provide a guaranteed, predictable, fixed monthly payment either for a limited period of time or for as long as you live, depending on the specific product. This can make it a more attractive choice for some retirees compared to more volatile investments like the stock market, though it should be noted that stocks can provide outsized returns compared to annuities over time.

This is especially true of fixed annuities, which provide a defined return on your investment.

2. Range of Choices

Of course, fixed annuities like the ones described above are not the only kind available. Another type of annuity is the variable annuity. Just like it sounds, the returns in a variable annuity are not fixed–they vary based on the performance of the underlying investments within the annuity.

The third kind of annuity is the indexed annuity. This kind of annuity typically tracks a market index like the S&P 500 but with a twist. Rather than tying your performance exactly to the index’s performance, since that could be accomplished by simply investing directly in an index fund, an indexed annuity will generally track the index while mitigating or even eliminating the downside risk in exchange for limited upside potential.

For example, a fixed-income annuity may track the S&P 500 with the following caveats:

  • If the S&P 500 is down this year, your annuity’s performance is unaffected.
  • If the S&P 500 is up this year, your annuity’s performance is capped at a 12% gain. So if the S&P 500 gained 10%, your performance would be 10%. But if the S&P 500 gained 20%, your performance would only be 12%.

And this is just scratching the surface of how complex and varied annuities can be.

3. Annuities Can Offer a Lifetime Benefit

Some annuities pay their owners a monthly payment for as long as they live. This can be a very attractive feature for someone who does not have a defined benefit retirement plan, such as a pension.

Individuals concerned about outliving retirement assets and living on only their Social Security payments may find a guaranteed income for life enticing.

4. Tax-Deferred Growth

Like Individual Retirement Accounts (IRAs), annuities aren’t subject to taxes until the owner begins making withdrawals. These withdrawals will be taxed as income, but only after many years over which the annuities have been able to grow tax-free.

Annuity Cons

Annuities certainly have some attractive features, but a potential purchaser must carefully weigh these features against the cons of annuities — starting with their cost.

1. Annuities May Be Expensive

There’s no way around it—annuities are expensive insurance products with a fair share of fees. And the cost of these fees could outweigh their benefits, depending on your specific situation.

Here are some of the most common annuity fees:

  • Agent’s commission. The commission, usually based on a percentage of your contract amount, is paid to the agent who sold you the annuity.
  • Mortality and expense risk charge. This is a fee paid to the insurance company for taking on the insurance risk of your annuity.
  • Surrender charge. This fee is charged if you withdraw money from your annuity before a certain period specified in your insurance contract.

Generally, the more complicated an annuity’s structure, the more expensive it will be. A simple fixed annuity, for example, will normally have much lower fees than more complex varieties.

2. Annuities May Be Illiquid

Annuities are generally not liquid investments. Once you enter into an annuity contract, the money you pay to the insurance company will likely be locked up for several years. You may be charged hefty surrender fees if you need to withdraw during this time.

Remember, annuities are generally designed to provide you with a stream of income in the future. They are typically not intended to be withdrawn from, particularly in the early years of their contract.

3. Annuities May Not Beat the Market

It’s quite possible that you would enjoy more income and greater wealth preservation in retirement by depositing money you would otherwise put in an annuity into simple, low-fee investment products such as passively-managed stock and bond funds. That said, annuities are fundamentally an insurance product used to hedge, partially, against the market risk of a traditional retirement portfolio, so perhaps a direct comparison of the “performance” of an annuity against the performance of a securities benchmark over time is not the most helpful vantage point.

So, before you dive in, make sure you fully understand the pros and cons of annuities. It’s best to consult with a financial professional to determine if this is the right fit for your specific retirement plan.

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