Pros and Cons of Annuities

How Do Annuities Work?

Annuities work by converting a lump sum premium into guaranteed income for a specified amount of time, whether it’s a few years or the rest of your life. There are many different types of annuities, each with their own features, benefits and drawbacks.

Some annuities, known as immediate annuities, start paying out income right away. Most annuities are deferred annuities, meaning they undergo an accumulation phase before converting the contract’s value into income payments.

Deferred annuities also contain many types, each of which accumulates value in a specific way and carries a different amount of risk. 

Types of Deferred Annuities

Fixed Deferred Annuity

A fixed deferred annuity is considered a very safe product that earns interest at a guaranteed rate.

Fixed Indexed Annuity

A fixed indexed annuity has a minimum guaranteed interest rate and earns interest based on an index’s performance, at a medium level of risk.

Variable Deferred Annuity

A variable annuity carries the most risk of any deferred annuity because its value is tied to the performance of underlying investments.

Every annuity product has its pros and cons. Before purchasing any annuity, you might find it helpful to work with a financial advisor who can help you understand which product is best for you.

Pros and Cons of Annuities

There are only three ways to guarantee a lifetime income: Social Security, pensions, and annuities. Annuities maintain a unique position in the retirement planning landscape because they are the only option consumers can use to create additional guaranteed income on their own terms.

Guaranteed income products like annuities require tradeoffs, which is why the purchase of an annuity should be done within the context of a holistic financial plan. Building an income plan that incorporates growth, guarantees, and flexibility is possible but requires utilizing various financial products, including annuities. Guaranteed growth or income is not often flexible, which can be the biggest downside of using annuities within a portfolio.

Stephen Kates, CFP®Principal Financial Analyst for Annuity.org

Stephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.

Pros of Annuities

Many people purchase annuities to take advantage of their beneficial features, which can help with tax planning, estate planning and supplementing income in retirement.

Tax Advantages of Annuities

Annuities provide tax-deferred growth. When you purchase a deferred annuity, your premium can grow year over year, and you won’t owe any taxes on that growth until you start taking income or withdrawals from the annuity.

When income payouts do begin, only a portion of the money you receive from the annuity is taxable income. This is the portion that represents the annuity’s growth over time.

Tax-deferred growth is a key advantage of annuities because it allows you to earn more over time. The money that taxes would take of the annuity is instead left in the account to further compound interest, resulting in greater growth.

The partial taxation of distributions only applies to non-qualified annuities, or those purchased with after-tax dollars. Qualified annuities are purchased with funds from a qualified retirement plan such as an IRA or 401(k). Because qualified annuities are purchased with pre-tax money, you’ll owe taxes on the entirety of the distributions you receive. 
Read More: Annuity Taxation

Guaranteed Income

An important benefit of many annuities, especially immediate annuities, is the potential to generate a lifetime income stream in retirement. Most people receive Social Security benefits when they retire, but that income often isn’t enough for retirees to maintain their lifestyle.

In previous years, pensions from employers provided a stable source of income retirees could depend on. However, pension offerings have sharply declined in the 21st century, and most employees today don’t have access to these types of plans. A recent Annuity.org survey found that only about a third of Americans aged 45 to 60 expect to receive income from employer-sponsored pension plans when they retire.

For many of those people, annuities can bridge the gap by offering a lifetime income stream to supplement Social Security benefits. When you purchase an annuity, you can choose different payout options, including payments guaranteed to last for the rest of your life or for the rest of your and your spouse’s life.

No Contribution Limits

Most tax-advantaged retirement savings plans have limits on how much you can contribute each year. In 2024, you can contribute up to $23,000 to a 401(k) and up to $7,000 to an IRA. 

Unlike a 401(k) or an IRA, an annuity has no limit on how much you can contribute. This makes annuities an attractive option for high-income earners who have maxed out their retirement plan contributions but still have money they want to grow tax-deferred for retirement savings.

Estate Planning Benefits

Annuities can be useful in estate planning for a few reasons. Because annuity contracts tend to have one or more named beneficiaries, they are able to avoid the lengthy and expensive process of probate.

The ability to name multiple beneficiaries can help you divide your estate more equitably. You can specify the percentage of the annuity’s value each beneficiary will receive in the contract, helping to avoid potential disputes and litigation among your heirs.

Contract Customization

Another significant advantage of annuities is the ability to customize your contract in several ways. If you have a fixed indexed annuity or a variable annuity, you can customize how the annuity accumulates value. 

A fixed indexed annuity might let you decide which index to tie your interest rate to or choose different crediting methods. When you purchase a variable annuity, you can select which investment subaccounts make up the portfolio that determines your annuity’s value.

The other way to customize any annuity contract is by purchasing riders for an additional cost. You can add riders to guarantee an enhanced death benefit for your beneficiaries or guarantee certain benefits while you’re still alive. A rider can provide benefits for long-term care services or increase your payouts each year to adjust for inflation. 

Cons of Annuities

Despite their many advantages, annuities aren’t the right product for every retirement investor. The disadvantages of annuities include high fees, limited liquidity and growth that doesn’t outpace inflation.

High Fees

One of the most common complaints about annuities is that they cost too much in fees and commissions. The amount an issuer charges in fees depends largely on the type of annuity you purchase; the more complex the product, the higher the fees.

Variable annuities are the most complex types of annuities, so they have the most fees. The fees associated with variable annuities can end up costing you about 2.2% of your annuity’s value each year on average, according to the Institute of Business & Finance.

Typical Variable Annuity Fees

• Administrative fees: To cover administrative and maintenance costs, the annuity provider may charge you a flat annual fee or a percentage of your account’s value.
• Mortality and expense charge (M&E): M&E charges typically cost about 1.25% of the account value each year, which pays the insurance company for the risk they assume that the annuity will be worth less than its guaranteed death benefit when the annuity owner dies.
• Underlying fund expenses: The insurance company will also charge a small percentage to pay the fees on the mutual funds that make up the annuity’s portfolio.
• Rider fees: Most variable annuities are sold with a living benefit rider, which incurs an additional fee; any other riders added to the contract will apply extra costs.

While only some annuities charge these fees, all deferred annuities have some form of surrender charge. 

Surrender charges exist to deter annuity owners from withdrawing their contract too early. They typically charge a percentage of the annuity’s value that starts high and declines year by year until the surrender period ends, at which point the owner can take distributions without penalty.

Limited Liquidity

Annuities charge a hefty penalty to owners who withdraw their contract before the surrender period elapses. This means once you purchase a deferred annuity, you essentially lock up your money for a specified period of time, typically between five and 10 years. 

Annuities are long-term investments, so it’s not a good idea to put into an annuity money that you may need in the near future. In such cases, it’s better to have a separate emergency fund you can dip into if necessary so you don’t need to take money out of your annuity early.

Inflation Risk

During periods of high inflation, the purchasing power of income diminishes, and consumers may need more money than they previously did to maintain their lifestyle. This can present a problem for those receiving a fixed income.

For most annuities, the income payments you receive stay the same amount for as long as you get them. When inflation occurs, that constant payment amount starts to be worth less than it was before. 

You can purchase cost-of-living riders that increase the value of your annuity’s payments by a little each year to help offset inflation. However, when you opt for this annual increase, your payments actually start lower, potentially increasing your inflation risk because the larger payments you receive later on won’t be worth as much.