An annuity is a financial product that pays an individual a fixed income stream through payments after making an initial investment. These financial products are primarily used as a way to create retirement income, but some high-wealth households can use them to secure enough future income to maintain a specific lifestyle. Financial institutions create and sell them, structured in either fixed, variable, deferred, or immediate income. It gives investors enough flexibility through this method to create a long-term financial plan.
Annuities can have an extended contribution period so that ongoing funding can occur with this product. It is also possible to use this product to turn a lump sum of cash, such as a lottery payment or a large judgment, into a long-term income opportunity.
If you have a significant amount of money and need diversification in your portfolio, then these are the advantages and disadvantages of annuities to consider today.
List of the Advantages of Annuities
1. An annuity can give you retirement income for life.
If you’re worried about outliving your money during your retirement, then an annuity makes sense from an investment standpoint. Although it may not help your wealth grow as an investment in stocks or bonds might, you can give yourself a steady stream of income for a set time. You can extend this period as needed to ensure that you never run out of cash with the various structures that are available.
This advantage is the fundamental reason why people purchase annuities. It hedges today’s money against longevity risks. It might also help some to increase their tax-deferred savings because it is easier to reach the maximum contribution levels.
2. Annuities provide guaranteed returns.
If you decide to invest in a fixed annuity, then you have a guarantee that you’ll earn a specific interest rate on your investment. Although the rates offered with this option tend to be lower than what other options provide, it also provides more predictability for future income planning.
3. Investors can receive protection from market volatility issues.
Although any investment provides a level of risk that investors must consider, some annuities can help to protect the cash in this product from downturns that happen in the market. If it experiences a decline after you purchase an annuity, then the value won’t get impacted by the market because you receive a guaranteed return.
That means a 2% fixed annuity will still give you that return even if the market decides to fall 4% in value for the year. You can also take advantage of a variable annuity to take the upside of market growth while using optional benefits to relieve losses from the downside.
4. Some annuities receive insurance coverage.
Some companies provide insurance coverage for your annuity investment so that you can receive the underlying principal back if something happens to the agency. You will want to ask about this feature before agreeing to any contributions to ensure that you can minimize your losses. Although there aren’t any guarantees even with insurance, you’ll eliminate the issue of losing everything if the company goes under for some reason.
5. You can reduce risk by gradually annuitizing.
Once you lock in an annuity rate, there’s the risk that interest rates can rise so that you miss out on some returns. Since these rates are partially based on the 10-year Treasury rate, you can try to time your purchase with the market’s movements to create a positive outcome. The time to buy is when you’re ready to transfer risk, so annuitizing gradually is an excellent option to consider.
By taking a more gradual approach, you’ll have access to more interest rates. It will also buy you time to get a better feel about how much you may need this investment product.
6. If you die early, then you’re not going to lose your money.
The insurance companies that offer annuities pool your money with that of other customers. Even if you die earlier than expected, you can structure this investment option to provide structured payments to a spouse or designated heirs. That means your money can continue to provide guaranteed protections to either yourself or the people you care the most about. The advantage here is the guaranteed protection more than the overall value you receive at the end of the policy.
7. You can sometimes choose how your money gets invested.
When you decide on a variable annuity for your investment, then most consumers often get to choose how their money gets invested. This process is similar to what it is like when you choose a mutual fund. You can always choose to invest directly instead of using this vehicle. It is an advantage that gives you more flexibility if you prefer a hands-off approach to investing. You can essentially deposit your cash, choose your options, and then forget about it until you need to access the payments.
8. A variable annuity can offer a death benefit.
Variable annuities carry some risk with them because they offer the potential of losing money. They also come with an extra benefit that you won’t find with other products in this category: a death benefit. That means the insurance company will offer payments or continue to pay out on the annuity to a designated beneficiary.
If you take out an annuity contract worth $100k, then that will likely be the payout your family receives with this benefit – no matter how the annuity performs. You can also take advantage of riders that can enhance this benefit as needed.
9. Several different types of annuities are available for investors to consider.
Insurance companies provide several different annuity options to consider for investors. Immediate annuities allow you to trade a lump sum of money to create an instant income stream. You can choose a fixed option to take advantage of the characteristics that are similar to a Certificate of Deposit.
If you choose a variable annuity, then you can take advantage of characteristics that are similar to that of a mutual fund portfolio. You can also use an equity-indexed annuity, although that option is for more specific situations.
10. Annuities can provide you with inflation protection.
You have the option to customize your annuities to ensure that your monthly income stays on pace with the current rate of inflation. That means you can maintain your current lifestyle because you’re staying at the same pace as the cost of living. Inflation can have a devastating impact on your finances, especially if it rises at 3% per year. At that rate, the money held in your pocket would be worth 30% less in just a decade – and that would directly impact what you could afford during your retirement.
When you combine the elements of predictability with this income stream and its ability to counter inflation, you have an effective combination that can supplement your other income resources so that you can maintain the lifestyle that you want.
List of the Disadvantages of Annuities
1. Annuities provide limited access to your money.
Most annuities come with a surrender period. That means you can’t take any money out of this investment product without incurring a hefty fee or penalty from it. Once you decide to start receiving payments from the annuity after the investment, then you can typically no longer withdraw additional funds from that account. That means you’ll only have access to whatever your structured payments are with the agreement you create upon purchase.
That means you can create the needed retirement income from a lump sum, but then you are unable to access the money if you have an emergency.
2. Several penalties and fees apply to virtually all annuity products.
Most annuities have fees that come attached to them that work to minimize the return that investors can earn. Some of the common costs include surrender charges, administrative fees, mortality expenses, and optional costs that come with specific riders. Some investors might also be subject to a tax penalty of 10% if you withdraw money before the age of 59.5. If the market has a down year and your annuity provides a fixed return, then the overall value of this financial product may decline.
3. It gets taxed as ordinary income when you receive payments.
The interest that you earn on an annuity before you receive payments will grow in a tax-deferred status. When you withdraw these funds, then the earnings and your past contributions get taxed as ordinary income, much like it is with a distribution from a non-Roth 401(k) or IRA.
For most people, their ordinary income rate is higher than the long-term capital gains rate. That means you’ll end up paying more in taxes with this option than you would with stock or mutual funds that you hold for at least one year.
4. Annuities may only be as good as the company selling it to you.
Most annuities get marketed as a way to have a guaranteed income during your retirement. If the agency that sells this product to you experiences financial difficulties or goes out of business, then you might lose the entire investment with a fixed or indexed product. This disadvantage is one reason to consider a variable product since you’d likely get to keep the underlying investment, but you’d still likely lose anything optional and all of your returns.
Before making a decision about an annuity, you will want to perform your due diligence to ensure that you’re working with a stable, reputable company.
5. Commission rates are high for annuities.
Most annuities get sold through brokers who can earn a hefty commission on the sale that you generate. Some of those can be as high as 10%. Some investors get caught off-guard by this disadvantage because the fee doesn’t get broken out for them, but that structure doesn’t mean you get to avoid the cost. It can sometimes get put into the operational fees that you get charged.
The easiest way to avoid this disadvantage is to purchase an annuity directly from a company that sells them to customers. Most low-cost brokerages offer a non-commission annuity for you to consider.
6. Most annuities will charge you an annual fee.
This disadvantage mostly applies to variable annuities, but it is still an issue that everyone should consider before finalizing their investment. It is not unheard of for some consumers to be paying upwards of 3% for the privilege of having a guaranteed income stream during their retirement. If you were to use a managed mutual fund instead, it may be possible to cut this cost by 50% while having more exposure to the market.
That figure applies to the total amount contributed to the annuity, so consider that a $200,000 product with a 3% annual fee is going to cost you $6,000.
7. You might lose most of your investment.
If you purchase a lifetime annuity with a lump sum of money for only yourself and didn’t pay the extra for a minimum number of payouts, then it is always possible that you could pass away in a couple of years. That means you’d receive very little of your investment as retirement income. The money that would have gone to your heirs remains with the annuity company instead. Although it is a worthwhile risk in many situations, it could result in a substantial loss.
8. Annuity growth isn’t always matched to stock market growth.
The stock market typically makes a gain during the year. A good year might see results of 10% or more. That means more money for your investments, but it isn’t a guarantee that the value of your annuity will grow. Indexed products in this category will often cap the gains through the participation rate. That means if your annuity has a 75% participation rate, then you’ll receive that percentage of the amount that the index fund grows.
You might also experience a growth cap on some annuity products. Your variable annuity might get capped at 8% growth. That means if the stock market rises by 20%, then you get the maximum 8% and the insurance company gets the rest. If a participation rate is part of that agreement as well, a 25% cut takes that to 6%.
9. The tax complications of an annuity can get pushed to your heirs.
If you sold specific assets during your lifetime, then you’d pay capital gains tax on the returns that you achieve. When you give this money to your heirs while alive, then your designated family members or associates inherit your cost basis. If you wait to pass them along until after your death, then they receive a step-up in their basis to the cost of the holding on your date of death.
Annuities that generate significant appreciation don’t receive this benefit. Your heirs will pay taxes at their ordinary income rate or get forced to distribute the policy and take the gain in short order. That results in a taxation time bomb that your inheritance might not cover in its entirety.
10. The surrender charge can be a long-term cost issue.
Actuaries need time to make the assumptions work when you purchase an annuity. Insurance companies need to make up for the losses that they pay in commissions to their agents. That means there’s a meaningful reduction in your payout that can descend for up to 15 years. It’s a massive hit that forces you to stay locked into this product in almost every circumstance. Even if you only have a five-year descension schedule, you could lose a significant portion of your initial investment because of this disadvantage.
Some people do not need an annuity. If you have enough money coming in from your Social Security payments and other retirement assets, then it isn’t necessary to receive these structured outlays. That means you can put the money toward other investments that might provide better returns or fewer tax consequences.
If you know that you have health problems that might make it challenging to reach your life expectancy targets, then an annuity wouldn’t make sense unless you want it as a way to support your family.
When evaluating the advantages and disadvantages of annuities, your good health can benefit from a stream of income that you won’t outlive. It gives you a way to provide for your family without much effort beyond the contribution of a lump sum of cash. As with any investment, it is a good idea to avoid putting all of your financial eggs into a single basket.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.