Whatâs in your annuity? Check under the hood.
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Annuities are one way you can set up regular income and sidestep a few money worries in retirement. But they typically come with high fees and hidden risks.
When you buy an annuity, youâre essentially buying a contractual promise from the issuerâtypically an insurance companyâto send you regular payments for a set period, or even for the rest of your life.
Key Points
- Annuities can offer guaranteed income in retirement, but there are pros and cons.
- Pros include guaranteed income, customization, and tax-deferred growth.
- Cons include complexity, high fees, and less access to your money if you need it early.
Annuities come in many forms, with many optional add-ons. With some, you start receiving payments right away. With others, payments donât begin until years later. Some annuities feature fixed payments, while the payments from others depend on market performance. Annuities are highly customizable, meaning you can mix and match many of these features.
All about annuities
Fixed, variable, immediate, deferred, rider, surrender charge. Confused? Britannica Money has a wide assortment of annuity-related content, including:
Annuities are complex investments that require research and thought before you hand over your savings.
Understanding the risks of annuities
Annuities are often used to create a steady income stream in retirement and to guard against two major risks:
- Market risk. Some folks look to annuities to protect their wealth in the event of a sustained market downturn that could make a huge dent in their life savings. With annuities, the risk is shifted to the annuity underwriter (typically an insurance company).
- Longevity risk. Outliving their money is a top concern among retirees and retirement savers. Although the average life expectancy in the United States is about 77 years, adults who reach age 70 can, on average, expect to live to 87. That may be longer than youâve saved for. An annuity with a lifetime income provision can help you sidestep that risk.
As individuals enter retirement, the appeal of a guaranteed income can be alluring. But annuities come with risks of their own.
In addition to their fees and complexity, the biggest risk of an annuity is that you lose easy access to your money. If you ever need to replace your car, pay for a medical emergency, help a family member, or even take a once-in-a-lifetime vacation, it may be impossible, or prohibitively expensive, to get the money from your annuity.
Building a comfortable retirement typically involves combining Social Security with other sources of income.
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Plus, not every annuity will protect you against losing money during a market downturn. With some annuities, such as variable annuities and indexed annuities, the performance of the annuityâs underlying investments can negatively affect your monthly payments.
Thereâs also the risk that the insurance company wonât deliver on the annuityâs guarantees. The possibility of the insurer becoming insolvent is remote, particularly if you stick with well-known, highly capitalized companies, but itâs not outside the realm of possibility.
Finally, annuity fees come out of your income. And income payments are set by a formula that may not take inflation into account. So, you run the risk that your annuity payments could be insufficient during periods of high inflation or anytime your monthly expenses suddenly increase because of a move, medical reasons, or other factors.
With an annuity, youâre really swapping one set of risks for another. The risk set you choose to accept will help you decide how to prioritize the pros and cons of annuities.
Annuity pros
- Customization. You can choose which features are important to you and pay only for those features. That might mean choosing a guaranteed level of income, participating more heavily in the stock market, or earmarking a fixed payout for your heirs when you die.
- Peace of mind. An annuity can provide the equivalent of a personal pension, meaning you donât need to worry about whether youâre withdrawing too much (or too little) from your savings each month.
- Tax-deferred growth. Any appreciation in the value of an annuityâs holdings (stocks, bonds, and such) is tax-free until the payments begin in retirement.
- Guaranteed income. Based on how much you pay and are willing to pay in fees, you can set a fixed level of income to receive from an annuity, as well as incremental increases to keep up with inflation.
Annuity cons
- Complexity. Annuities are complicated and personalized. If youâre not familiar with all the stipulations of your specific annuity contract, you may face unwelcome surprises in retirement.
- High up-front costs. Because annuities are so complex, they come with higher commissions for financial advisorsâsometimes as high as 8%. Depending on how the annuityâs fees are structured, that can mean the annuity investor may start retirement minus a sizable chunk of their assets.
- High fees. Most annuity contracts charge higher maintenance and operational fees than similar mutual funds. On top of those charges, youâll pay additional fees for any extra guarantees you choose, known as contract riders.
- Low liquidity. For the first few years (and sometimes longer), an annuity owner will have to pay high surrender fees to take more money out of the annuity than just the agreed-upon payments.
The bottom line
Annuities arenât for everyone. If your ideal retirement is one in which your finances are both simplified and guaranteed, then annuities may be worth a look. But when buying an annuity, itâs essential to study the ins and outs of the contract, along with the associated fees.
This article was most recently revised and updated by Colin DoddsThis article was most recently revised and updated by Doug Ashburn
