Pros and Cons of Annuities: What You Need to Know

With numerous investment options available to supplement your income during retirement, evaluating which plan is best can seem like a daunting process. Insurance advisors have placed clients’ investments in annuities for decades, yet the practice has its detractors. Are annuities a good investment? Read on to learn about the pros and cons of annuities and determine whether an annuity may be right for you.

What Are Annuities?

An annuity is a legally binding contract with an insurance company that provides a guaranteed income stream to a person for life. Annuities transfer the longevity risk — the potential for a person to outlive their savings — to the insurance company. An annuity investor pays a lump sum or series of payments as outlined in the contract. The insurance company uses a strategy to invest and grow your assets over time, and then you receive guaranteed payments for life.

How Do Annuities Work?

The annuity process has two distinct parts:

• Growth period: During the accumulation and growth period, you place your taxable or after-tax assets into the investments recommended by the annuity company. You then wait for the investments to appreciate. 
• Annuitization period: When you are ready to receive payments, the contract enters the annuitization period. Your insurance company then provides a lump sum or makes monthly, semiannual or annual payments.

Fixed vs. Variable Retirement Annuities 

Retirement annuities can be fixed or variable. Fixed annuities are the simpler version, and the rate of return remains the same for the duration of the contract. Variable annuities introduce a higher element of risk because the rates can fluctuate depending on market conditions and other factors. There are a couple of other differences:

• Fixed annuities: In this arrangement, clients pay a fixed rate of interest. A set payment is guaranteed during the agreement term, meaning the value cannot shrink or grow. Low risk, fixed annuities deliver low returns, and payments lose their value over time unless you pay extra for a plan that takes inflation into account.
• Variable annuities: The interest rate and value of these annuities are variable. These annuities fluctuate based on the invested mutual fund returns, so the value has a chance to increase or decrease over time. You run the risk of lower payouts, as you are dependent on the success or failure of the market.

The Pros and Cons of Fixed Annuities

A fixed annuity contract can make sense for risk-averse investors who wish to avoid taking chances with their funds. The guaranteed income these options provide can make retirement planning easier and more predictable and provide peace of mind. 

On the downside, the fixed rate may not keep pace with rapidly rising inflation. Retirees face the risk of outliving their money if they depend too heavily on these annuities for long-term income. 

The Pros and Cons of Variable Annuities

While variable annuities increase the risk for the investor, they could also yield a much higher return than their fixed counterparts. They can be a more viable option for long-term investment situations because an extended time frame often safeguards against market fluctuations. 

Unpredictability is the most significant disadvantage for many people regarding variable annuities. A sharp market downturn could result in substantial losses. These products can also have higher management fees.

Indexed Annuities

Indexed annuities combine the characteristics of fixed and variable annuities. Returns depend on the stock market index’s performance, yet contract provisions can limit the benefits of market growth reaching the client.

While some investment professionals present indexed annuities as a way to mitigate the risks of a variable annuity, the growth limitations inherent in these contracts tend to minimize the return.

Immediate vs. Deferred Annuities 

You can choose an immediate or deferred annuity, depending on whether you prefer regular income to start now or in the future.

Immediate annuity payouts begin the moment the client makes a lump sum payment to the insurance company. Immediate annuities are designed to provide you with income payments within one time period after the annuity purchase. If you purchase a monthly annuity, you receive your first payment one month after its purchase date.

A deferred annuity grows your investment over time. Similar to an Individual Retirement Account (IRA) or 401(k) plan, annuities accumulate tax-free earnings until you withdraw the money. The deferment period can last for decades before payouts begin. 

The Pros and Cons of Annuities 

While an annuity can provide a guaranteed income for life, the plans are complicated and expensive. Before you invest, evaluate the pros and cons to determine whether a retirement annuity is right for you: 

Pros: The Benefits of Annuities

The advantages of an annuity may include the following:

• Tax deferral: The money you contribute to an annuity is tax-deferred, allowing your investment to grow without taxation. No tax is owed on your money until you begin receiving payments. 
• Guaranteed returns: While fixed annuity returns might be limited, they are guaranteed. Fixed annuities contractually warrant you will make a percentage on your principal investment. So even if that percentage is low, you are guaranteed to earn more than the original investment amount. 
• Regular payments: Annuities provide regular payments from your insurance company, offering scheduled supplemental income during retirement that could help if other savings are inadequate to cover everyday expenses.
• Death benefits: Variable annuities offer the potential for a death benefit, which is a payment made to your designated beneficiary in case of death. Many death benefits equal the amount you contributed to the annuity. If your contract is worth $150,000, the payout is the same. Variable annuities can have enhanced death benefits. The insurance company pays a death benefit equal to the highest recorded value of your annuity, even if the value declines due to market fluctuation closer to your passing.
• Fraud protection: Retirement annuities are essentially immune to scams and financial fraud. Because an annuity is an irrevocable contract between the investor and the insurance company, no third party can access your money during the growth or annuitization period.

Cons: The Disadvantages of Annuities

Disadvantages of annuities to consider include:

• Tax penalties: If you want to withdraw money from the annuity before age 59 1/2, you must pay a 10% tax penalty to the Internal Revenue Service (IRS) in addition to other taxes owed on the income.
• Low returns: While guaranteed, annuity returns tend to be very low. Risk-concerned investors tend to focus on the short term, which investment companies utilize to sell annuities. Remember to consider the long-term risk of your investment potential being so limited that your gains fail to keep up with inflation and living expenses. Just because a return is guaranteed does not inherently make it safe.
• Expensive commissions and fees: Compared to other investments, annuities heap fees onto the process, including administrative and risk fees, mortality charges, commissions and penalties. Every tacked-on charge eats away at your investment. Unlike companies that put the potential profit made from annuity commissions above the interests of their clients, a commission-free and fee-only investment firm will not tack on gratuitous financial hooks.
• Surrender charges: If you need access to annuity money before a contractual time period has passed, usually a six-year minimum, the insurance company issues a surrender charge. Surrender fees can significantly reduce your return on your investment.
• Locked-in money: Immediate annuities are difficult, or near impossible, to get out of if you wish to invest your money elsewhere. Except for death benefits afforded to variable annuities, you cannot remove your investment or pass it to a beneficiary once you contribute to an annuity, even if you have funds left.
• Gains capped by annuity fees and participation rates: In a bull market year, the stock market makes gains, which means you should make more money from your investments, right? Not necessarily. When you invest in an annuity, your returns may not grow by the same amount as the market due to expensive fees. And your insurance company can cap gains using a set participation rate — meaning you miss out on benefitting from any profits above that locked-in rate.
• Lack of inflation protection: Fixed annuities issue fixed payments each month or year once you start withdrawing from the policy. The problem with a locked-in payment amount is the cost of living increases over time due to inflation. As years pass after retirement, the value of your issued payments will continue to diminish during a time in life when you need to count on its value. The inflation vulnerability of annuities affects your financial security for food, medical costs and living expenses.

Should I Buy an Annuity?

Before you sign any contracts, consider the numerous reasons why annuities are bad investments. While annuities are marketed as a way for retirees to supplement income with regular payments, the inflation and high cost of fees greatly diminish the value of your potential income payments. 

To protect your retirement financial security and growth, meet with a commission-free CERTIFIED FINANCIAL PLANNER™ to discuss a diversified retirement plan that is right for you.

Plan Your Retirement and Financial Future With HSC Wealth Advisors

If you are considering an annuity, we recommend developing a diverse financial plan that follows best practices designed to increase your long-term results and meet your retirement needs for years to come.

At HSC Wealth Advisors, we pride ourselves on offering trusted, comprehensive advice that puts you first, always. Our advisors have upheld the highest degree of integrity and professionalism for more than 30 years. With our fee-only firm, you can rest assured your investment plan is safe from any surrender charges, lockup periods or financial hooks.

Contact us to talk to an advisor about your retirement and financial aspirations today!