SHORT ANSWER: Annuities aren’t the best investment option for most people, but if you value predictability and don’t mind high fees, they can be a good choice.
Annuities are financial products that provide a regular income stream in exchange for a lump sum payment or periodic contributions.
Are annuities good investments? Whether annuities, offered by insurance companies, are a good investment depends on your financial goals, risk tolerance and financial situation. While annuities can provide guaranteed income in retirement, they often come with high fees and restrictive terms that may make them an unsuitable choice for some investors.
Retirement planning is essential to ensure you have enough savings to maintain your desired lifestyle after leaving the workforce. Are annuities better than nothing? Absolutely. But are annuities a wise choice? Take a closer look at what they are and weigh the potential pros and cons.
What Are Annuities?
An annuity is a financial product sold by insurance companies that provides a stream of payments to the holder at regular intervals. They are usually intended for retirement income. However, they are not the only way to save for retirement, and there are other investments for retirees that offer stable returns with lower fees.
The three main types of annuity available are:
- Fixed annuity: Pays out a fixed, guaranteed interest rate and return.
- Indexed annuity: Return is tied to a stock market index, usually the S&P 500.
- Variable annuity: Allows you to invest in a range of funds, with the potential for higher returns but more risk. The term “variable” is used because the returns you’ll get vary.
Are annuities a good investment? The pros and cons below can help you decide. For a more detailed overview of annuities, see this guide to annuities. Many states also offer advice on annuity investments, including California, Michigan and Maine.
What Are the Benefits of Annuities?
There are several significant benefits to annuities.
Guaranteed Income Stream in Retirement
If stable income is your No. 1 priority, annuities can offer a strong advantage. With a fixed annuity, you're guaranteed a certain income for a set number of years. Keep in mind that to get a comfortable income, you may need to make a significant lump sum investment or higher regular monthly payments.
Tax Advantages and Deferred Taxation
Annuities offer significant tax advantages comparable to other retirement accounts. Annuity taxation varies depending on whether you purchased annuities with pretax or post-tax dollars.
Funds in annuities grow tax-free. If you paid for the annuity with pretax dollars, you will pay income tax on withdrawing funds or when you begin receiving payments. You will only owe taxes on the gains if the annuity was purchased with post-tax dollars.
Protection Against Market Volatility
Investing in annuities, especially fixed-rate annuities, could protect you against market volatility. Even in the case of market downturns, you're guaranteed regular payments.
Potential for Long-Term Financial Security
Investing in annuities can offer the potential for long-term financial security through investment growth. Guaranteed annuity payments ensure stable income, regardless of market performance or other economic factors.
Variety of Annuity Offerings
There are various annuity offerings, allowing individuals to choose a personalized plan. While some investors may prefer the security of a fixed annuity, others choose indexed annuities for potentially higher returns. Variable annuities offer the potential for higher returns by investing in a range of funds and asset classes like stocks, giving you greater long-term growth potential.
What Are the Disadvantages of Annuities?
While annuities offer significant advantages, there are also risks. Weigh these cons before investing in annuities.
Limited Access to Funds and Potential Penalties for Early Withdrawals
Once you invest in annuities, you usually cannot withdraw funds before retirement without facing penalties or fees. Consider your need to access funds in case of unexpected events and how an early withdrawal could affect your overall wealth.
Fees and Expenses Associated With Annuities
Annuities are infamous for their high fees and commissions charged by insurers and salespeople. Compared to other investment classes, like mutual funds, index funds or brokerage accounts, annuities may have higher fees and expenses. These can significantly eat into your investment returns over time. Compare various annuities' expenses to choose the best options for you.
Lower Returns Compared to Other Investment Options
Depending on the type of annuity you choose, investing in annuities can offer lower returns than other investment classes. This is especially true of fixed annuities, where you gain stability and guaranteed income but sacrifice potential gains.
Potential Inflation Risk and Loss of Purchasing Power
When you purchase annuities with guaranteed income, the purchasing power of a dollar will decline over time because of inflation. That means that a specific guaranteed income purchased 30 to 40 years prior may not comfortably sustain your lifestyle through retirement because of inflation and the decreasing purchasing power of the dollar.
Early Withdrawal Penalties
Annuity contracts typically include surrender charges for withdrawals made during an initial surrender period, often lasting five to 10 years. These charges can be steep. If you decide an annuity isn’t for you, you could lose substantial funds to these penalties.
Lack of Liquidity
Because of the withdrawal penalties, annuities are relatively illiquid investments compared to regular brokerage accounts, Roth individual retirement accounts (IRAs) or IRAs. Access to your money is limited, which can be a major disadvantage if you face financial hardship.
Complexity and Fine Print
Annuity contracts are lengthy and filled with complex rules, exceptions and fine print that can be difficult for the average investor to understand.
Alternatives to Annuities
Before purchasing annuities, consider investment alternatives.
- Traditional retirement accounts, including IRAs and 401(k)s: These tax-advantaged accounts allow you to invest and grow wealth tax-deferred. Learn more about IRAs or 401(k)s, including types of individual retirement accounts.
- Individual stocks and bonds: Individual stocks and bonds are the traditional investment categories to build retirement wealth. Learn how to trade stocks or how to buy bonds.
- Real estate investments: Real estate investments, including rental properties, real estate investment trusts (REITs) or crowdfunded real estate, offer strong historical returns and investment diversification. These can also offer cash flow through dividends or rental payments.
- Mutual funds and exchange-traded funds (ETFs): Mutual funds or ETFs, including index funds, offer a passive option to invest in many stocks and create a diversified investment portfolio.
Is an Annuity Right for Your Retirement Plans?
Annuities can be a valuable tool for securing guaranteed retirement income, but they are also notoriously complex products that come with high fees, early withdrawal penalties and other fine print. Whether an annuity makes sense depends on your retirement goals, risk tolerance and portfolio needs.
Investors should carefully weigh the pros and cons before committing a large portion of their savings to an annuity and may be better off in an indexed fund. However, if you’re approaching retirement age and want a fixed income, considering annuities can be worth it. Interested in other options? Learn how to open a Roth IRA or how to create multiple income streams. You can also check out how much you need to retire and find the average retirement savings by age to help you reach your targets.
Frequently Asked Questions
Why are annuities a poor investment choice?
The main drawbacks of annuities are their high fees, lack of liquidity because of surrender charges and complexity. These factors can outweigh their potential benefits for some investors.
Who should not buy an annuity?
Annuities may not be suitable for younger investors who want full access to their money or for those prioritizing maximum growth over guaranteed income. They can also be poor choices for low-income individuals or anyone who wants to save on fees when investing.
Can you lose money with annuities?
With fixed and indexed annuities, you cannot lose your principal investment because of market downturns. However, with variable annuities, you can lose money because you are invested in funds tied to the market.
What is better than an annuity for retirement?
For many investors, a diversified, risk-balanced portfolio of low-cost stock and bond index funds within tax-advantaged retirement accounts like a 401(k) or IRA could be a better long-term option than an annuity. You can speak with a financial advisor if you’re unsure of the best options for your situation.
About Alison Plaut
Alison Kimberly is a freelance content writer with a Sustainable MBA, uniquely qualified to help individuals and businesses achieve the triple bottom line of environmental, social, and financial profitability. She has been writing for various non-profit organizations for 15+ years. When not writing, you will find her promoting education and meditation in the developing world, or hiking and enjoying nature.