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Annuities can be useful tools when it comes to retirement. But they may not be right for everyone. So, when considering whether to purchase one, it’s useful to understand their advantages and disadvantages.
Basically, an annuity is a contract where, in exchange for a payment or a series of payments, an insurance company will provide a guaranteed stream of payments to someone either immediately or sometime in the future. As such, they offer a number of advantages for retirement and financial planning.
“An annuity takes a lump sum of savings and turns it into a stream of income for a period of time, typically covering one or two lives or for a certain number of years,” said Doug Collins, financial planning director for Fortis Lux Financial in New York City. “This can accomplish many things such as ensuring certain fixed expenses will be met no matter what.”
Pros of annuities
Guaranteed retirement income. This is probably the biggest advantage of an annuity for most people.
“While there’s no one-size-fits-all solution, many annuities offer a consistent and guaranteed income stream, which is particularly helpful when planning for a financially secure retirement,” said Jon Preston, CFP®, a financial professional with Commonwealth Financial Group in Needham, Massachusetts.
Sure, there can be other sources of income in retirement. The two most likely are Social Security and income generated from savings in qualified retirement accounts, like 401(k)s and individual retirement accounts (IRAs). In addition, some people may have pensions, although such programs are on the decline.
Beyond those, some people may also have investment portfolios or assets purchased during their working years that generate income, like an Airbnb rental or a share in a business.
But there are risks associated with all these income sources. Income-generating assets are subject to the vagaries of demand. Markets can get volatile, negatively affecting returns and even the overall value of investments. Additionally, retirement savings face sequence of returns risk.
As noted, pensions are on the decline as more companies phase them out. And Social Security is facing funding questions, which may result in changes to benefit levels and when those benefits can be claimed.
A guaranteed, stable source of income offers peace of mind for all those risks and questions. An annuity provides that. And it can provide that income for life.
Diversified retirement income. This goes hand in hand and even amplifies the point above. But in a different way.
As most seasoned investors know, it’s unwise to put all your financial eggs in one basket. Market downturns, sometimes severe, happen periodically. The same with commodity markets. And, as seen in 2008, real estate can drop dramatically in value. And the still young crypto market is an ongoing lesson in ups and downs.
Diversification helps guard against an overall loss in portfolio value by dividing investments among different markets and financial vehicles. The guaranteed income stream provided by an annuity can be an effective part of that strategy.
Tax-deferred growth. Money invested in annuities that will pay out at a future date (called deferred annuities) grows tax-deferred.1 That means taxes aren’t assessed until payments from the annuity start, when many people expect to be in a lower tax bracket in retirement.
How much the funds in an annuity grow depends on the type of annuity. Fixed annuities, for example, offer fixed rates of return, which some people may regard as a positive in and of itself. Other kinds of annuities can tie growth to the performance of various markets. That introduces an element of risk to growth, but also offers the possibility of greater gains over time, which some people may view as a positive as well. (Learn more: Different types of annuities explained)
Greater contribution limits. Qualified retirement accounts, such as 401(k) plans or IRAs, have IRS-imposed annual contribution limits (respectively $23,000 and $7,000 in 2024). You can put much more into an annuity, provided that it’s not part of a qualified retirement plan, up to limits set by the issuing company. And you can buy multiple annuities.
This makes annuities appealing for those who may want to save more for retirement than qualified retirement plans allow.
Customizable. Also, riders — living benefits that can be added to the annuity contract at an additional cost — can help modify an annuity contract to address specific concerns or needs of a buyer. A spouse, for example, could add a death benefit rider to provide benefits to their partner should they pass away. Or someone may want to structure an annuity in a way that offers both guaranteed income and market growth.
Also, there are a variety of annuities available that can address specific situations. For instance, there are annuities that can establish an immediate income stream. And there are others that can help reduce required minimum distributions from qualified retirement plans to later years. (Learn more: What is a QLAC?)
Cons of annuities
Nothing in the financial world comes without possible disadvantages for some people. Annuities are not an exception.
Fees and commissions. Annuities can come with a wide range of costs.
Some of the more complex types of annuities have fees related to managing complicated investment structures. By the same token, some simpler kinds of annuities have very little or even no fees involved. It depends on the type of annuity and the amount of management needed to accomplish its goals.
“Some types of annuities can have high fees in return for the guarantees associated with them, but these vary with the specific product as the term ‘annuity’ can mean a wide range of solutions, and costs vary across the spectrum,” noted Collins.
Additionally, all financial products have costs tied to their creation, marketing, and management. And in the case of an annuity contract, it costs an agent and an insurance carrier a significant amount of time and money to create and administer an annuity contract, given the various sales, operational, and legal costs involved. And those costs are recouped either through fees, commissions, or a combination of the two.
Withdrawal limits, inaccessible funds. Money needs time to earn a return. That’s how investment works. In the case of an annuity, an insurance company needs to be able to count on the funds being there for an investment return over a certain amount of time, because it is guaranteeing payments to the annuity owner in the future.
So, annuities come with restrictions on when and how much money can be withdrawn.
“Annuities often have surrender periods and penalties for early withdrawal, which limits their liquidity,” noted Preston. “Proper planning can mitigate this drawback, which is why it’s so important to work with a qualified professional to understand the risks and rewards.”
Indeed, surrender charges are applied to withdrawals within certain time periods, typically in the first seven years of the investment. So, planning ahead on when funds from an annuity may be needed is vital.
Surrender charges act as a deterrent to withdrawing money for short-term needs, which allows the insurance company to manage annuity funds more efficiently and use the money for longer-term investments with traditionally higher returns. (Related: Understanding surrender charges)
“Typically, once an annuity turns into that income stream, the purchaser of the annuity loses access to some or all of the lump sum they contributed, so overall liquidity is important to consider when thinking about annuities,” Collins warned. (Learn more: Understanding annuitization)
Inflation risk. Annuities guarantee a predetermined level of payments either immediately or in the future. Should inflation spike, as it has in the last couple of years, then the buying power of those set payments would diminish.
However, it is important to note that some annuities allow for fixed increases in payments over time.2 Also, as a consequence of interest rate hikes that typically happen in response to inflation, fixed annuities that offer higher growth rates become available.
Specific drawbacks. There are different types of annuities aimed at accomplishing different goals. What might be advantageous for one type of investor may not be for another. So, it’s important to pick the right annuity for the right situation.
For instance, some annuities are geared toward building long-term, tax-deferred growth over time, which may make them more appropriate for people with a longer retirement horizon. But others aim to provide a guaranteed stream of income either immediately or at some defined point in the future. That may make those kinds of annuities more appealing to those arriving at or close to their retirement years. But not for those with a longer time horizon.
Annuities also tend to draw a certain amount of criticism, typically tied to comparing their performance to that of mainstream market investments. Such criticism tends to overlook the risks involved in market investments and that annuities are more of a financial tool. (Related: Common annuity criticisms … and rebuttals)
Conclusion
In the end, the weight given to the pros versus the cons of annuities depends on the needs and goals of the investor. The advantages of annuities, like guaranteed lifetime income, may not make sense for some investors against some the drawbacks, such as illiquidity. Many people opt to consult a financial professional about what makes the most sense for their situation.
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1 Annuities do not provide any additional tax deferral if purchased in a qualified plan type, such as an IRA. An annuity purchased under a qualified plan should be done for the benefits offered under the annuity.
2 When an annuity offers inflation protection to their annuity payments, payments are usually smaller than if no protection increase is provided.