Pros and Cons of Annuities

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Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on July 12, 2023

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Annuities Overview

Annuities are financial products typically provided by insurance companies to help individuals secure a steady income during retirement.

They're designed to accept and grow your funds, then pay out a regular stream of income at a later point in time, often during retirement. The primary purpose of annuities is to provide a reliable, consistent source of income, making them a critical tool in retirement planning.

There are several types of annuities, including fixed, variable, and indexed. Each of these types offers different returns and risk levels.

Fixed annuities provide a guaranteed return, variable annuities offer returns tied to a market index, and indexed annuities provide a combination of guaranteed returns and potential market-based gains.

Understanding how each works is crucial to making an informed decision about whether annuities are the right fit for your financial situation.

Pros of Annuities

Guaranteed Income

A significant benefit of annuities is the guarantee of income, which can be structured to last a lifetime or a certain period. Lifetime income ensures you will receive payments until you pass away, while certain period income provides payments for a defined period, such as ten years.

Tax Deferral Benefits

In the accumulation phase, the money you invest in an annuity grows tax-deferred, meaning you don't pay taxes until you withdraw the funds.

This allows your money to compound faster because you're earning returns on the full amount of your investment, including the portion you would have paid in taxes.

Protection From Market Volatility

With fixed and indexed annuities, you're protected from market downturns. Your investment is insulated from the daily fluctuations of the financial markets, providing a stable and predictable income stream.

Options for Spousal Continuity and Beneficiaries

Annuities offer options for continuation of income to a spouse after the annuitant's death, known as a joint-life option. There are also death benefit options that allow a beneficiary to receive the remaining funds upon the death of the annuitant.

Inflation Protection

Some annuities offer options that help protect against the eroding effects of inflation. These features may come in the form of Cost of Living Adjustments (COLAs) or increasing payment options.

Potential for High Returns

Variable annuities, while risky, can offer high returns if the underlying investments perform well. Additionally, some annuities offer bonus credits, which are extra amounts added to your account as a percentage of your premium payment.

Cons of Annuities

High Fees and Costs

Annuities can come with a range of costs, including surrender charges for early withdrawal, ongoing management fees, and insurance charges. These costs can significantly reduce the value of your investment over time.

Limited Liquidity

If you need to access your money before the end of the surrender period (usually several years), you'll likely face steep surrender charges. Annuities are designed for long-term income, not for quick access to cash.

Complexity and Transparency Issues

Annuities can be complex products with various fees, features, and guarantees. This complexity can make it difficult for average investors to fully understand what they're investing in. There can also be transparency issues, with some fees or risks not clearly disclosed.

Risk of Insurance Company Failure

Your annuity is only as secure as the insurance company that sells it. If the insurer fails, you could lose your investment. While there is some protection through state guaranty associations, it's generally limited.

Possible Lower Returns

Compared to investing directly in the stock market, you might see lower returns from an annuity, particularly a fixed annuity. Additionally, if you die soon after buying an annuity but before you've received much income from it, you or your heirs may receive less than the original investment.

Tax Disadvantages

Unlike capital gains or qualified dividends, any gains from annuities are taxed as ordinary income. Plus, there is no step-up in basis at death, which could result in higher taxes for your heirs.

Pros and Cons of Annuities

Considerations Before Investing in Annuities

Before investing in annuities, there are several important considerations to keep in mind.

First, understand the specific terms and features of the annuity, including fees, surrender charges, and any potential penalties for early withdrawals.

Assess your own financial goals and risk tolerance to determine if an annuity aligns with your needs. Consider the length of the annuity contract and whether it suits your long-term plans.

It's also crucial to research and evaluate the financial strength and reputation of the insurance company offering the annuity.

Finally, consult with a financial advisor to ensure that an annuity is a suitable component of your overall investment strategy.

Conclusion

Annuities offer distinct benefits, including guaranteed income, tax deferral advantages, protection from market volatility, options for spousal continuity and beneficiaries, inflation protection, and potential for high returns.

However, it's essential to balance these with certain drawbacks such as high fees, limited liquidity, complexity, potential insurance company failure, the possibility of lower returns, and some tax disadvantages.

Prior to investing in annuities, significant considerations should be taken into account. These include clearly defining your financial goals, understanding the diverse types of annuities, assessing the financial health of the insurance company, and engaging a financial advisor.

Weighing these elements, annuities could play a pivotal role in your financial planning strategy. Nevertheless, this investment vehicle isn't a one-size-fits-all solution and should be carefully considered to align with individual financial goals and risk tolerance.

Pros and Cons of Annuities FAQs

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About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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