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Insurance agents and financial advisors have been investing their clients’ retirement money in annuities for decades.
This practice has its detractors, with the criticism usually focusing on the high commissions paid to annuity salespeople and stiff fees charged to annuity owners year after year.
In fact, if you compare the costs of an annuity to those for a mutual fund, you’ll find that a mutual fund is much less expensive. So it pays to know the details about annuities before you invest.
Here’s a rundown of the pros and cons of annuities and how they compare with other ways to invest for retirement.
Key Takeaways
- Annuities can provide a reliable income stream in retirement, but if you die too soon, you may not get your money’s worth.
- Annuities often have high fees compared to mutual funds, ETFs, and other investments.
- You can customize an annuity to fit your needs, but you might need to pay more or accept a lower monthly income.
- If the insurance company that issued your annuity goes broke, you may lose your money.
How Annuities Work
An annuity is a contract between an investor and an insurance company. The investor contributes a sum of money—either all up-front or in payments over time—and the insurer promises to pay them a regular stream of income in return.
Immediate or Deferred
With an immediate annuity, that income begins almost immediately. With a deferred annuity, it starts at some point in the future, typically during retirement.
The dollar amount of the income payments is determined by such factors as the balance in the account and the age of the investor.
Annuities can be structured to pay income for a set number of years, such as 10 or 20, or for the life of the annuity owner.
When the owner dies, any money remaining in the account typically belongs to the insurance company. However, if they live happily to, say, 120 years old, the insurance company has to keep those regular payments coming.
Fixed or Variable
Annuities also can be fixed or variable. With a fixed annuity, the insurance company pays a specified rate of return on the investor’s money.
With a variable annuity, the insurer invests the money in a portfolio of mutual funds, or “subaccounts” chosen by the investor. The return fluctuates based on their performance.
The Pros of Annuities
Despite the criticisms, annuities do offer some advantages for investors who are looking toward retirement.
Guaranteed Income
The insurance company is responsible for paying the income it has promised, whether for a specific time period or however long a person lives. However, that promise is only as good as the insurance company behind it.
This is one reason investors should only do business with insurers that receive high ratings for financial strength from the major independent ratings agencies.
Customizable Features
Annuity contracts can often be adapted to match the buyer’s needs. For example, a death benefit provision can ensure that the annuity owner’s heirs will receive something when the owner dies.
A guaranteed minimum income benefit rider promises a certain payout regardless of how well the mutual funds in a variable annuity perform.
A joint and survivor annuity can provide continued income for a surviving spouse.
All of these features come at an additional cost, however.
Money-Management Assistance
Variable annuities may offer a number of professional money-management features, such as periodic portfolio rebalancing for investors who’d rather leave that work to someone else.
The Cons of Annuities
High Commissions
Commissions charged for selling annuities are almost always higher than those charged for mutual funds.
Say that an investor rolls their $500,000 balance in a 401(k) into an individual retirement account (IRA). If the money is invested in mutual funds, the financial advisor might make a commission of about 2%.
If it is invested in an annuity that holds the same or similar mutual funds, the advisor could make a commission of 6% to 8%, or even higher.
Therefore, a $500,000 rollover into mutual funds would pay the advisor a $10,000 commission at most, while the same rollover into an annuity could easily pay the advisor $30,000 to $40,000 in commission. Not surprisingly, certain advisors will direct their clients into the annuity.
High Fees
Most annuities do not assess sales charges upfront. That may make them look like no-load investments, but it doesn’t mean they don’t have plenty of fees and expenses.
Annuity contracts impose annual maintenance and operational charges that often cost considerably more than the expenses associated with comparable mutual funds.
This has been changing somewhat in recent years, and some insurers are now offering annuities with comparatively low annual expense ratios. Still, as always, investors should scrutinize the fine print before they sign.
Surrender Charges
If an annuity owner needs to get money out of the annuity before a certain period of time has elapsed (typically six to eight years, but sometimes longer), they may be subject to hefty surrender fees charged by the insurer.
No Added Tax Benefits Over IRAs
Annuities are tax-sheltered. The investment earnings grow tax-free until the owner begins to draw income. If the annuity is a qualified annuity, the owner is also eligible for a tax deduction for the money they contribute to it each year.
A traditional IRA or 401(k) has the same tax benefits. Plus, if invested in conventional mutual funds or ETFs, it typically costs much less than an annuity.
Importantly, investing in an annuity through your 401(k), as investors may be urged to do by some salespeople, is redundant (because both are tax-advantaged) and needlessly expensive.
In other words, why use your retirement plan contribution to buy an already tax-sheltered product when you can invest in higher yielding taxable securities that will then grow tax-deferred?
Important
If you’re planning to buy an annuity, make sure that you’re dealing with a financially solid insurance company that’s likely to be around—and able to make good on its promises—when you start drawing income.
A Compromise Solution
If you like the idea of an annuity but not the potential long-term cost, there’s a practical solution. You can invest in mutual funds, ETFs, and other investments until retirement. Then move some of your money into an annuity, especially one with a downside protection rider.
That can keep the fees to a minimum during your working years and guarantee a steady income in retirement. Consider consulting with a tax advisor about the tax implications of this approach.
Can You Lose Money With Annuities?
With certain annuities, such as an immediate annuity, a deferred income annuity, or a fixed annuity, you can’t lose money in the way that you can with investments tied to the market. On the other hand, you can lose money with a variable annuity whose underlying funds fluctuate in value. You can also lose money with any annuity if the insurance company that issued it goes out of business and defaults on its obligation. There is a degree of regulatory protection for investors in case this happens.
Why Are Annuities a Poor Investment Choice?
What Is Better Than an Annuity for Retirement?
The Bottom Line
Though annuities are one of the most established retirement savings options, they aren’t necessarily for everyone.
Annuities work for people who are looking for simple, fixed payments—and who don’t mind the disadvantages, such as high fees.
When considering an annuity, be sure to pay attention to all of the details in the contract. Evaluate all of the pros and cons, and contact a reputable financial advisor if you have any questions.
