What Are the Disadvantages Of An Annuity? Here Are the Pros and Cons
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Summary:
There are several disadvantages to annuities that may make them a poor investment choice for some. For instance, annuities can be quite expensive, especially if you need to access your money before you turn 59.5. Because of this, it’s rather difficult to ensure you make back your initial investment if you plan to annuitize too late in life. While you can purchase death benefits to mitigate these losses, these are also expensive and may simply not be worth it.
Most of us start dreaming of our retirement the moment we join the workforce. Unfortunately, just about everything these days is more expensive than we may realize. More and more often, people are realizing that retiring on the nest egg they stashed away just won’t cut it when it comes to covering their monthly budget.
If this sounds like your situation (or a situation you’re young enough to plan to avoid), you may find that an annuity can help make your ends meet. When an annuity makes sense for you, it really makes sense, as they can allow you to invest your income tax-deferred, thus maximizing growth over time, and provide guaranteed income once you annuitize (cash in). However, annuities also have a number of downsides to keep in mind.
Keep reading to learn more about annuities, when they may be right for you, and the risks involved in purchasing one.
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What is an annuity?
An annuity is an agreement you enter into with an insurance company in which, in return for an initial or ongoing investment, they agree to repay you in installments at a later date. However, different annuities may differ in payout and risk level, making them suitable for some and undesirable for others.
Do you want monthly payments now or later?
The first major distinction is when you want your annuity payouts to start. Deferred annuities are purchased with the intent to contribute to the fund for several years. Once the agreed-upon period is over, the fund is annuitized and monthly payments begin.
When an immediate annuity is purchased — usually with one lump sum from a retirement savings account — monthly payments begin immediately.
How risky do you want to get?
From there, you can decide how your money grows, which of course involves different levels of risk. You have three options to choose from:
- Fixed annuities. If you’re a risk-averse investor, you’ll likely prefer fixed annuities, which are the lowest risk. They offer guaranteed income, but the prospect for growth is lower. You know you’ll get a certain amount of money every month, but those payments will usually be on the low end of the spectrum.
- Indexed annuities. Also called “fixed indexed annuities,” this kind of annuity ties the growth of your fund to a particular stock index (e.g. the S&P 500). So, if the market does well, you get more money (and vice versa). Despite this connection, indexed annuities have some protection from huge losses. The flip side of that is that you’re also prevented from taking full advantage of market gains.
- Variable annuities. These funds are directly invested in the market, so they are 100% tied to its success or failure. A variable annuity offers the greatest growth potential but also the highest risk of losing money.
When you should avoid annuities
Now that we understand the basics, we can talk about when it might not be in your best interest to purchase an annuity. If your financial situation falls into one of the scenarios below, you may want to wait before purchasing an annuity.
1. If you won’t retire until much later in life, and death benefits are too expensive.
If you’ve done your retirement planning and it looks like you’ll be working into your 70s or beyond, an annuity might not make sense for you. Annuity income comes in the form of monthly payments, and the regular income payments you’ll receive from even the most successful of variable annuities are unlikely to recoup your original investment in under 20 years.
Annuity holders bet their money that they’ll live long enough that the insurance company pays back as much or more than they initially invested. As bleak as this may sound, if you do the math and living another 20 years doesn’t seem like a safe bet, you may want to consider other options. And while you could choose to purchase death benefits, the cost of this may reduce your monthly payments enough that they no longer cover the gap in your budget.
2. If you need access to your money before you retire.
Annuities can be a great choice for guaranteeing an income stream after retirement. That being said, if you end up needing that money before then, it’s going to cost you.
Most annuities will assess surrender charges if you ask for your money back before a certain period of time (normally six to seven years, but could be as long as 10 years). This is on top of the 10% tax penalty for early withdrawals (before age 59.5) you’ll be charged by the IRS.
3. You don’t need to cover a deficit in your monthly budget.
If your monthly finances are covered, an annuity may not offer you the best option for growing your wealth post-retirement. Investing in the stock market or mutual funds could be more lucrative, and wouldn’t carry the fees associated with an annuity.
When you should get an annuity
Fortunately, there are scenarios in which the flexible benefits of annuities make them an attractive option for some retirees. Let’s take a look at a few of them.
1. You’ve retired and have a deficit in your monthly budget.
If the retirement income provided by social security and/or your pension is insufficient to cover your monthly expenses, you either need to reduce those expenses or find supplemental income to cover that gap.
Many retirees aren’t interested in going back to work, so using savings to purchase a fixed annuity may be a great way to cover a budget gap, since it will guarantee you additional fixed income every month.
One thing to consider, however, is that, while fixed annuities do provide guaranteed income, this isn’t going to be enough money to take up residence in Maui. If your deficit is large, a fixed annuity is unlikely to be able to cover it.
Pro Tip
You can check out an annuity payment calculator to get an idea for how much monthly income you could generate with the cash you have on hand. What’s more, most companies that sell annuities offer free quotes on their services, which will be more accurate to your particular situation.
2. You expect to retire with plenty of life left to live.
One of the potential pitfalls of an annuity is that you have to live long enough to recoup your investment or it’s not worth it. The way annuity payments work, it can often take 20 or 30 years to get to the point where you’ve gotten back as much money as you put into your annuity fund.
However, if you’re planning for your retirement and can reasonably expect to annuitize your savings relatively early (e.g. in your 60s) and live into your 80s or 90s, you’ll likely recoup the investment you initially made via monthly payments.
3. You want your money to grow tax-deferred.
If you’re in the position to purchase a deferred annuity, you’ll get the benefit of your money growing tax-free while you wait to cash out. This will allow you to build up a larger retirement nest egg than if you invest in a traditional retirement savings account, which taxes you before you invest your money.
IMPORTANT! Keep in mind that you aren’t eliminating the need to pay taxes here, merely kicking the can down the road a bit.
4. You want protection against downside market risk.
Indexed and variable annuities offer the potential for market-based returns while protecting your money from a downward move in the market, typically in the form of a return floor or a buffer. For example, an indexed annuity tracking the S&P 500 may have a performance floor of -10%, which means in any given year, your account could lose up to 10%, but not any more than 10%. So if the S&P 500 goes down 25% for the year, your account would only lose 10%.
On the other hand, if your annuity had a buffer of 10%, then the insurance company would “eat” or take the first 10% of market loss. If the market fell 5%, your account would not lose any money (0% return). However, if the market falls 25%, the insurance company would take the first 10% of the loss and your account would realize a -15% return.
Pro Tip
In addition to these protection features, there is often a performance cap sometimes as low as 10%. So, if the market goes up 15%, your account would only realize a 10% gain. Keep this in mind when deciding whether to purchase an annuity.
5. You want to designate beneficiaries to receive payments after you’ve died.
Most insurance companies will allow you to purchase death benefits, which allow you to designate beneficiaries to receive your monthly payments for a time after you die. This way you can benefit from the monthly income an annuity provides without worrying that you’ll throw a huge chunk of cash away if you don’t live long enough to recoup your initial investment.
Keep in mind, however, that death benefits aren’t free. You’ll likely be charged up to 20% for this service.
6. You want to make large contributions to your retirement account.
The IRS caps the amount of money you can contribute to a traditional or Roth IRA account at $6,000 per year ($7,000 if you’re over 60). However, these restrictions are looser if you’re contributing to an annuity or a 403(b).
For these plans, you can contribute up to $61,000 per year. So, if you have the extra money to invest, and you want to maximize your tax-deferred growth, an annuity might be the way to go.
Pros and cons of annuities
As you can see, annuities can offer a great source of income for some retirees. However, there are several disadvantages of annuities that may not make them right for your future retirement.
What is a better alternative to an annuity?
It depends entirely on your situation. If you need to cover a monthly income gap, an annuity could be your best option. If you’re looking to grow your wealth or need to have more immediate access to your money, however, more traditional investment options may be better for you.
To further explore your investment options during retirement, you may want to speak with an investment advisor. They’ll be able to make recommendations based on your specific situation and retirement plan.
FAQs
Can you lose money with annuities?
Unfortunately, you can absolutely lose money with annuities. There are three main ways this can happen:
- You don’t live long enough to recoup your initial investment through monthly payments.
- If you purchase a fixed annuity, you miss out on market success because your fixed annuity doesn’t grow with the market.
- You suffer from market losses because your variable annuity is vulnerable to market fluctuations.
What does Suze Orman say about annuities?
Quite a lot. Her main advice (largely summarized from her article on the subject) is that annuities are great for some folks and a scam for others. You should always consult financial advisors before making these decisions, but also be aware that they do make commissions on annuity sales, so maybe take their annuity enthusiasm with a grain of salt.
Should a 70-year-old buy an annuity?
You should ask your financial advisor for advice when considering making any investment. That being said, it’s generally not a good idea for a 70-year-old individual to purchase an annuity. The statistical math on living long enough to recoup investments at that point isn’t great, and the cost of death benefits will likely be hefty. However, if you can find an annuity agreement that repays your original investment within a reasonable amount of time, or can afford to add on a death benefit, it could make sense.
Again, ask an investment professional and they will consider your specific situation and help you make the choice that’s best for you.
Key Takeaways
- Annuities can be a safe way to ensure you earn a set amount of income every month.
- Annuities can also allow you to grow your money in a tax-deferred manner, which means it will make more money over time.
- Fixed annuities are the safest, but offer the least opportunity for growth. Variable annuities, on the other hand, are riskier but offer the potential for higher growth.
- Keep in mind that annuities tend to be more expensive than traditional investments, especially if you need to access your money before you’re 59.5 years old.
- Annuities are also unlikely to make back their initial investment if you annuitize too late in life.
- Purchasing death benefits can be a way to mitigate some of this loss for your designated beneficiaries, but they can be quite expensive.
Related reading: Still considering an annuity despite the disadvantages outlined above? If so, you’ll want to know all you can about cashing in your annuity before you commit. Read Cashing In an Annuity: Updated Guide… to learn what you need to know.
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Ben Coleman is a veteran English teacher with a knack for translating complex concepts into bite-sized chunks. Having recently dug himself out of crippling credit card debt, he's passionate about providing excellent financial resources to folks who need them so they don't end up in the same position. Ben writes for SuperMoney from Rochester, NY where he lives with his wife and dogs (Yoshi and Pig).
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