The pros and cons of annuities (2024)

Insurance exists to protect us from the risk of the unknown and recover losses resulting from events beyond our control. After all, the best drivers still get into accidents, the healthiest people still get sick and even the safest houses occasionally fall victim to random acts of nature.

What about the risk of not having enough money for retirement? Likewise, even the best savers get hit with an unforeseen event that could derail their financial plans.

Annuities are one of the most popular ways to guard against that risk. However, there are pros and cons of annuities for retirement, and the products are often complex and controversial.

What are annuities and how do they work?

Annuities are contracts purchased either in a lump sum or over a set period of time, and they pay out a specific amount based on the investment strategy and amount invested. They can provide guaranteed income for an individual or their spouse throughout retirement, helping to alleviate concerns about outliving savings.

Simply put, annuities are a form of insurance to protect against the risk of running out of money in retirement. This is one of the main reasons they are so popular among savers, with an estimated $2.52 trillion of retirement assets in annuities in 2021, according to Statista.

Participants select and purchase annuities from an insurance company for an upfront cost. The insurance company invests the money, which earns interest over the duration of the plan. Once the participant, or annuitant, decides to receive payments, they receive the original investment amount plus interest, minus fees to cover administrative costs and other expenses. Those payments are then delivered as income during retirement, according to the National Council on Aging (NCOA).

The money invested is usually not accessible until the annuity payout begins, and investors may be charged a penalty for taking money out early. And because annuities are intended for retirement, they may be subject to additional tax penalties if cashed out before the age of 59 1/2.

What are the different types of annuities?

Annuities come in a variety of flavors to meet different financial goals, payout time frames and fee structures:

Immediate annuity: Annuitants make a single, lump-sum premium payment, and payouts begin within one year.
Deferred annuity: Annuitants (you) make payments into the annuity during an accumulation period, and payouts begin at a set date in the future.
Fixed annuity: Payouts are typically fixed and based on an amount guaranteed in the contract, putting the investment risk on the insurance company. Fixed annuities are some of the most predictable investments with guaranteed payments and duration, according to the NCOA.
Indexed annuity: Guarantees a certain return while providing an option to share the investment earnings.
Variable annuity: The payout is not guaranteed, although the contract may offer a minimum guarantee at an additional cost. Variable annuities fluctuate in value, and there is a risk of losing the principal investment altogether.

Who are annuities for?

Since annuities are such a varied form of insurance product that are available in forms where the vehicle’s investment characteristics — which also may vary — often are emphasized more than the insurance value, annuities can be appealing to a broad number of people depending on the issue or problem they are looking to address.

For those who are worried about having a steady income stream in retirement that is guaranteed for the rest of their life, a simple solution is a single-premium immediate annuity.

Those who want guaranteed income to start somewhat later in life may be interested in a qualified lifetime annuity contract, or QLAC, which is a deferred income annuity funded from a qualified retirement account, such as a traditional individual retirement account (IRA) or 401(k), where the lifetime payments can begin as late as age 85.

For those who want the option to enjoy a steady income stream for life but also are interested in a tax-advantaged way to save for retirement, a variable annuity might be a solution.

Key advantages of annuities

Income stability and annuities

Fewer people receive pensions today, and Social Security doesn’t provide enough income for many people to cover basic living needs. An annuity can help ensure you don’t outlive your other retirement savings, such as a 401(k). This can be especially helpful for those who could not contribute enough savings to a retirement plan, or may outlive their savings.

Fixed interest rates and annuities

Relying solely on investment portfolios to meet living expenses in retirement is complicated. If retirees regularly draw down on their investment principal, they must decide which investments to trim and by how much while diligently rebalancing the portfolio, according to Fidelity Investments. And that doesn’t take into account the impact that short-term volatility can have on retirees’ savings.

A fixed-income annuity can deliver consistent monthly payouts in retirement that don’t change based on markets, eliminating the need for any ongoing investment management.

Tax benefits of annuities

Any gain or interest in an annuity grows without taxation until the participant withdraws it. Typically this is done after retirement, when most people have a lower tax rate. Unlike IRAs, 401(k) plans and other tax-advantaged savings accounts, there is no limit to the amount of money someone can put into an annuity, according to Wells Fargo.

Drawbacks of annuities

Inflation

After a year-over-year rate of inflation sitting at a staggering 9.1% in June 2022, the current rate of inflation sits at 3.1% as of February 2023. Periods of high inflation, like that which consumers have experienced over the past few years, diminish the buying power of an annuity’s predetermined monthly payout in the short term, but the impacts can be even worse over a longer period. According to AARP, inflation is the single biggest risk to annuities.

“What will my paycheck buy in 25 years? Well, if inflation goes back to the 2.2 percent long-run average since 2013, my $535 monthly paycheck will buy me about $311 of goods and services. If inflation stays at 8.5 percent, it buys only about $70,” wrote Allan Roth, a practicing financial planner, for AARP in 2022. “Although you can buy [an annuity] that has a fixed annual increase, those actually have more inflation risk, since your paycheck is less in the early years but the larger payments in later years buy far less.”

Giving up liquidity

Some annuities require a lump sum of cash to be paid up front in exchange for the promise of regular, reliable income in retirement. If unexpected costs arise, annuitants aren’t able to get that money back without paying large fees and taxes.

Fees and expenses in annuities

Annuities are complicated financial products, and individuals should be careful not to enter into contracts without full awareness of every stipulation. Annuities often come with high commissions for the insurance agent or investment broker selling them — sometimes as high as 8% for fixed index annuities, according to Annuity.org — that can take a chunk out of your expected retirement assets.

Annuities also charge higher maintenance and operational fees than products like mutual funds and exchange-traded funds (ETFs), and they often include additional fees if you opt for income guarantees called “riders.”

Choosing the right annuity for you

Charles Schwab recommended that all investors consider four questions before purchasing an annuity:

What kind of annuity is it?
How much will the annuity cost?
What are the tradeoffs?
How will the annuity work with my other income?

“When considering annuities and whether a particular type of annuity fits your needs, do so in the context of all your retirement income, savings, investments, and assets, and determine which purpose each income stream will serve,” according to Schwab’s website. “If you understand the details, having a baseline of income from an annuity in combination with your investments can provide the combination of protection, flexibility, and potential for growth you need to enjoy retirement.”

Strategies for using annuities

Annuities come with many tax advantages, chief among them that investments within the contract grow tax-deferred. Tax-advantaged growth can be a lure for many investors, especially those who max out their contributions to other tax-advantaged savings and investment vehicles, including IRAs and workplace-qualified plans like 401(k)s and 403(b)s. Because the tax-advantaged investment feature of annuities comes at a cost — usually high commissions paid to those who sell the products and fees charged by insurance companies for the complexity of managing them — most financial planners and advisors recommend maxing out on IRAs and workplace plans first before considering annuities as investment vehicles.

For those interested in the lifetime income feature of annuities — known as annuitization — there are several strategies to consider.

When buying an immediate annuity upon retirement, for example, an individual makes a lump sum contribution and, in turn, foregoes a considerable sum of investable assets. In return, however, the annuity provides a guaranteed lifetime stream of monthly or quarterly income that is usually considerably greater than what the annuity principal could produce as income if remaining invested in a safe government bond.

That is possible because insurers know that some people covered by their annuities will die earlier than others, enabling the insurance company to offer more to those living longer. With higher assured income, annuitants (those receiving annuity payments) may be able to cover some or all of their fixed expenses in retirement, enabling them to invest their remaining funds more aggressively and increase the chances of having extra income for discretionary expenses.

Alternatives to annuities

While no investment can provide the lifetime guarantee or the higher stream of income that annuities can provide through insurers’ unique ability to pool mortality risk, there are many ways investors can earn safe, regular income from other investments.

One way is through the process of laddering, or buying several interest-paying, safe investments that mature sequentially. For example, one could buy a series of insured bank CDs or Treasury securities with maturity dates that are three months, six months, nine months and a year away. Every three months, an investment would mature and return the principal invested, which could be reinvested. The investment would also pay the owner interest, which could be spent.

Another way of providing regular income is to own a portfolio of dividend-paying, conservative stocks, such as the shares of highly rated utilities or major, blue-chip companies, with a long record of paying regular dividends that also tend to increase. A sufficient portfolio of such stocks could yield a predictable level of quarterly income.

Additional reporting by Evan Cooper.

Frequently asked questions (FAQs)

Annuities are taxed when the participant withdraws money or receives payments. Withdrawals from annuities purchased with pre-tax funds are taxed as ordinary income.

If the annuity was purchased with after-tax money, only the annuity’s earnings and interest are taxed. Taking annuity payments before the age of 59 1/2 could result in an additional 10% tax.

You can’t lose money if you invest in either a fixed annuity, fixed index annuity or deferred income annuity. Variable annuities, however, are investment-based retirement savings products, meaning returns are based on the performance of the chosen investment products, according to New York Life.

“If these investments don’t perform well, you could lose money. Some variable annuities offer the option to invest in index-linked accounts which track the performance of an index up to a cap, with principal protection,” said New York Life. “There is a potential to lose money if you choose to allocate your money in the variable investment option sleeve of the product, but money allocated to the index-linked account has a floor that limits how much you could lose each year.”

Annuities inspire a range of opinions from those working in finance. Some welcome annuities as security and protection against downside risk, while others claim the complexity and fees make them unsuitable for most investors. The truth is somewhere in between.

Purchasing an annuity is highly dependent on each person’s unique financial needs, goals and risk tolerance.

For example, Mary Beth Franklin, a certified financial planner and president of RetirePro, was in her mid-50s during the 2007-08 financial crisis. A 30% market drop could devastate someone close to or already in retirement, so she took some of her nest egg and bought an annuity, a decision she said she has never regretted.

“The thing people need to understand is a lot of investment guys would say [annuities are] expensive and you can make more money in an index fund, and it’s true, but you have no guarantee that index fund will always go up,” Franklin said. “When you’re in retirement, you want to know that a part of your income is guaranteed.”

People who can guarantee that their fixed costs will be met by a pension or some other source of retirement income can probably avoid annuities, she said. The products also make more sense for those in middle age than for younger savers, who have more time to recover from significant market drops.

Annuities are complex, and it could be worth meeting with a financial advisor to answer specific questions about your situation and goals. If you do, be sure to ask the advisor if they receive any commissions for recommending annuities (or other investment products).

“It’s important to remember that annuities are a product that is not bought, they are sold,” said Franklin.