Annuities: Retirement Savior or Financial Trap?

Annuities have long been promoted as a reliable way to generate income in retirement. The allure of guaranteed lifetime payments—like you would get from company pensions that are almost non-existent nowadays—makes annuities particularly attractive, especially during times of market volatility. However, as with anything that seems too good to be true, you might ask: What’s the catch? Before committing to an annuity contract, it’s crucial to understand the intricacies involved.

What is an Annuity?

An annuity is a financial contract between you and an insurance company. You make a lump sum payment or a series of payments, and in return, the insurer promises to make periodic payments to you, either immediately (with immediate annuities) or at a future date (with deferred annuities). You can also make a tax-free 1035 exchange from a life insurance policy or an annuity to another annuity.

Types of Annuities

There are three main types of annuities: fixed, variable, and indexed. Fixed annuities provide a stable, predetermined interest rate, like 3% a year, for a few years, after which the interest rate can change based on current rates. This type offers predictable income but limited growth. In contrast, variable annuities allow you to choose investments in stock, bond, and money market funds. Their value can fluctuate based on market performance. Indexed annuities are a hybrid of fixed and variable annuities, offering a minimum guaranteed rate plus returns linked to a market index like the S&P 500, balancing risk and potential return ⁽¹⁾.

Annuities can be either qualified or non-qualified, depending on how they are funded. Qualified annuities use pre-tax money from retirement plans and are fully taxed upon withdrawal. Non-qualified annuities use after-tax money, with only earnings taxed at withdrawal.

Why Do People Purchase Annuities?

The fundamental advantage of annuities is providing lifetime income, which protects retirees from outliving their assets ⁽²⁾. Annuities accomplish this by using mortality credits, which are funds from annuitants who die earlier than expected, to pay those who live longer than predicted. In addition to the straight life annuity payout, annuities offer other options such as “period certain,” which guarantees payments for five to 20 years, and “joint and survivor,” which continues payments as long as either the owner or a secondary annuitant is alive.

These predictable periodic payments aid in budgeting and financial planning. For investors who find it hard to stomach market fluctuations, fixed annuities offer protection of their principal from market downturns. Retirees who have a stable income tend to experience greater happiness and enjoy longer lives ⁽³⁾. Even those with shorter lifespans can enjoy the benefit called “license to spend,” which is spending without the fear of running out of money later ⁽⁴⁾.

Annuities often include death benefits (for free or at extra cost) to ensure your beneficiaries receive payments after you pass. They could receive either the total amount you paid into the annuity minus any withdrawals and fees, or the current account value, whichever is greater. Some annuities offer enhanced death benefit riders for an extra fee ⁽⁵⁾.

Another benefit of annuities is tax-deferred growth, i.e., you don’t pay taxes on the earnings until you start receiving payments. The earnings portion is taxed as ordinary income whereas the principal is generally free of tax. However, if you invest in an annuity through a tax-advantaged retirement plan like a 401(k) or IRA, you won’t receive extra tax benefits.

In some states, annuities are protected from creditors and bankruptcy. For example, Florida and Texas have laws that prevent creditors from seizing funds in annuities or cash value life insurance policies.

The Downside of Annuities

Annuities do come with trade-offs that you should consider before purchasing one.

First, annuities are not risk-free, and company or credit risk is one of them. You should remember that annuities are only as secure as the insurance company backing them, so make sure you’re confident in the insurer, not just the product. Annuities have limited protection from state insolvency guaranty programs with limits ranging from $250,000 to $500,000.

Annuities are also complex, with many different types and features, and can be costly. They often come with various fees, including commission (which could be in the 1% to 8% range, usually built into the price of the annuity), mortality and expense fee (ranging from 0.5% to 2% per year), administrative fees (around 0.15 to 0.3% per year) ⁽⁶⁾, investment-expense ratio (fees charged by the mutual funds or sub-accounts within variable annuities, usually between 0.5% to 2%)⁽⁷⁾, and additional costs of riders (add-on features that let you customize the contract). Altogether, the annual fees could add up to 3.5% of your contract value and thus reduce your returns ⁽⁸⁾. Many investors and financial advisors find annuity fees troubling. Some annuities even include market value adjustments that can affect the amount you receive if you withdraw funds early.

Another point to keep in mind is that with annuities, you often lose a significant degree of control over your investment. Most annuities require a significant investment that locks up your money. This means you won’t have easy access to cash for emergencies. If you withdraw before a specified (surrender) period (usually 5–15 years), you’ll face surrender charges, which usually start high (like 5% to – 25%) and decrease over time (like by 1% each year). Additionally, withdrawing before age 59 ½ can result in hefty tax penalties. Besides the liquidity risk, variable annuities also have investment risk, as your returns depend on the underlying investments chosen by the insurance company.

Furthermore, fixed annuities have inflation risk because they usually lack cost-of-living adjustments. Hence, their purchasing power can decline over time. When inflation protection is available, it generally comes at a significant cost. In addition, fixed annuities’ interest rates can change after an initial period, potentially reducing your returns. Locking in a rate, you risk missing out if interest rates rise ⁽⁹⁾.

Another risk to watch out for is death risk. You don’t know exactly when you will die, and due to specific provisions, some types of annuities may not provide any financial guarantee for death benefits. You may be able to get a rider to allow your beneficiaries to receive some money, but again, it likely comes with a fee.

When it comes to tax planning, keep in mind annuity gains are taxed as ordinary income, which can be higher than capital gains tax rates for other taxable investments. Unlike stocks or real estate, annuities don’t get a step-up in cost basis when the owner passes away. This means the beneficiary will owe taxes on the difference between the original purchase price and the contract value at the time of the owner’s death.

Finally, many annuity buyers, especially seniors, can fall victim to scams. A common trick involves an agent who highlights the benefits of an annuity but conveniently omits the fees and commissions ⁽¹⁰⁾. “In exchange for a promise of future rewards, the elderly individual ties up his or her life savings—money that may have been needed for essentials like food, housing, or medical care. Meanwhile, the agent pockets a handsome commission,” states the Center for Life Insurance Disputes, a firm that handles life insurance complaints on behalf of clients ⁽¹¹⁾.

Are Annuities Right for You?

Annuities can be a vehicle for retirement planning, but they aren’t for everyone. In a study of lifetime income strategies carried out by Morningstar in 2022, it was found that annuities aren’t helpful for those with wealth exceeding 36 times their annual retirement needs (defined as the difference between annual expenses and Social Security income). These retirees can self-insure for a long life. Annuities are also not that beneficial for those who rely on Social Security or inflation-adjusted pensions to meet most of their expenses ⁽¹²⁾.

The Morningstar study recommends trying the Social Security bridge strategy before opting for annuities. This involves delaying Social Security until age 70 for a bigger monthly check while using more of your assets to cover expenses in the meantime. Social Security benefits grow by about 8% each year from full retirement age to 70 ⁽¹³⁾.

Feeling overwhelmed by retirement income options like annuities? A Resource Consulting Group financial advisor can simplify things for you. They’ll assess your unique circumstances, goals, and risk tolerance, helping you decide if an annuity fits your holistic financial plan. Plus, they’ll navigate the market’s complexities to find suitable solutions for you to live your ideal retirement life.

Sources:

1. Investor.gov. “Annuities”. https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/annuities
2. Babbel. 2008. Wharton Financial Institutions Center. “Lifetime Income for Women: A Financial Economist’s Perspective”. https://ahe.illinois.edu/files/2019/11/Lifetime-Income-for-Women.pdf
3. Clements. 2005. The Wall Street Journal. “The Secret to a Happier Retirement: Friends, Neighbors and a Fixed Annuity”. https://www.wsj.com/articles/SB112241804795796704
4. Blanchett, David and Michael Finke. 2021. Retirement Income Institute. “Guaranteed Income: A License to Spend.” https://www.protectedincome.org/wp-content/uploads/2024/06/RP-28_BlanchettFinke_v2.pdf
5. Marquit. 2023. Prudential. “What are annuities and how do they work?”. https://www.prudential.com/financial-education/what-are-annuities
6. Schell. 2024. Annuity.org. “How Much Does an Annuity Cost?” https://www.annuity.org/annuities/fees-and-commissions/
7. Plummer. The Annuity Expert. A Guide to Variable Annuities. https://www.annuityexpertadvice.com/types-of-annuities/variable-annuity/
8. Rodeck. 2023. Kiplinger. “Annuities: 10 Things You Should Know”. https://www.kiplinger.com/retirement/annuities/annuities-things-you-should-know
9. FINRA.org. “Investment Products – Annuities”. https://www.finra.org/investors/investing/investment-products/annuities#risks
10. Egan. 2023. Forbes. The Pros and Cons of Annuities. https://www.forbes.com/advisor/retirement/pros-and-cons-of-annuities/
11. The Center for Life Insurance Disputes. “Annuity Fraud”. https://cflid.com/annuity-fraud/
12. Look, Szapiro. 2022. Morningstar – Center for Retirement & Policy Studies. “The Retirement Plan Lifetime Income Strategies Assessment.” https://www.morningstar.com/lp/lifetime-income-strategies-assessment
13. Brooks. 2023. U.S.News. What Raising the Retirement Age to 70 Would Mean for You. https://money.usnews.com/money/retirement/social-security/articles/what-raising-the-retirement-age-to-70-would-mean-for-social-security

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