Annuities can be valuable tools for retirement planning, offering guaranteed income and long-term financial security. However, they also come with notable drawbacks that can impact flexibility, inheritance planning, and overall costs. Understanding both the advantages and limitations can help you decide whether an annuity aligns with your retirement goals. By looking closely at how annuities work, what they offer, and where they may fall short, you’ll be better prepared to make a confident, informed decision.
What Exactly Is an Annuity?
An annuity is a financial product designed to provide a steady stream of income, typically during retirement. In simple terms, you give an insurance company a lump sum or a series of payments, and in return, they agree to pay you a set amount on a regular schedule. Some annuities begin paying immediately, while others grow over time before payouts start. They are commonly used to supplement Social Security or pension benefits and help ensure long-term financial stability.
Understanding the Benefits of Annuities
Before weighing the concerns, it helps to recognize why annuities appeal to many retirees. Annuities are designed to provide a predictable income, reduce uncertainty, and support long-term financial stability. For individuals who worry about outliving their savings or who prefer steady, dependable payments over market volatility, the structured nature of annuities can be particularly reassuring.
Lifetime Income
The main reason to buy an annuity is that it will provide a lifetime income once you retire. In fact, that’s the primary selling point. It’s much like a defined benefit pension plan that you might receive through your employer. Annuities are often attractive if you are concerned about outliving your savings.
They typically provide income in retirement that you can not outlive. You could potentially outlive a traditional retirement fund, unless it’s quite large. This is one of the reasons many people are delaying retirement, or un-retiring altogether. If you have modest savings, an annuity can provide a monthly income stream to supplement your Social Security.
Guaranteed Rate of Return
This positive benefit does not apply to all annuities. There are what are known as “variable annuities,” where the rate of return depends on the performance of the stock market. However, there are also “fixed annuities.” They provide you a guaranteed rate of return (say, 2% annually) over a specified period of time, regardless of the ups and downs of global markets. This type of guaranteed return can be attractive to seniors who would rather have a predictable income stream in retirement. You might favor it over weathering the fluctuations of equity markets.
Deferred Taxes
Another strong selling point of annuities is that they generally come with tax-deferred status. With other retirement investments, you are often stuck paying taxes on capital gains or when the investment reaches a set maturity date. With annuities, however, you don’t pay any tax until you withdraw the funds. This provides you with some control over when they pay your taxes. Leaving money in a deferred annuity can help reduce the amount of tax you pay on Social Security benefits. You will have less taxable income when you delay withdrawals.
Important Drawbacks to Consider
While annuities offer meaningful advantages, they also come with limitations that can impact your broader financial picture. Issues such as inheritance restrictions, high fees, and limited inflation protection can significantly influence long-term value. Understanding these concerns ensures you’re fully aware of the trade-offs before committing to an annuity contract.
Fees and Extra Costs
Annuities often come with large upfront fees. They are typically in the form of sales commissions, which can be as high as 10% of the lump sum you’re depositing. You might also see charges as high as 7% if you tap your funds before a “surrender period” has expired. Surrender periods usually range from two years to more than 10 years.
Other fees and costs associated with annuities include administrative fees and management fees. There’s also a host of expensive add-ons (or riders) for items such as the aforementioned survivor benefit. Each of these can cost as much as 1% of the policy’s value per year. These extra costs can hurt your annuity payments in one of two ways. Some riders lower your monthly payments at the outset by a fixed dollar amount. Alternatively, the cost of other riders is taken from a percentage of your annual investment returns. Either way, the fees and extra costs on annuities will overall diminish your retirement income.
Not Adjusted to Inflation
Most annuities are not adjusted for inflation, which means you’ll receive the same level of income at age 85 that you did at age 65. Never mind that the cost of living will continue to rise. Consider what could happen to your standard of living in retirement as prices for groceries, medication, and fuel continue to rise while your annuity income stays the same. Your purchasing power and standard of living will slowly be eroded.
Some annuities offer the ability to index your payments to inflation, but that requires you to tack on an inflation protection rider. That’s an optional feature that raises your payouts on the anniversary date of your annuity contract each year. Basically, you can arrange to have the payments you receive increased by the annual inflation rate. However, inflation protection riders can be expensive. They will reduce the amount of income you receive from an annuity at the very start, to make up for the increased payments over time.
A Few More Things To Consider
Now that we’ve gone over the basic pros and cons, let’s go over a couple more things that can help you decide whether annuities are right for you.
Your Overall Health
In some ways, buying an annuity is like betting on yourself. Or to be more specific, you’re betting that you won’t pass away before getting paid back. The best-case scenario when buying an annuity is that you outlive your original investment and continue to receive payments until you pass away. So if you’re in good health and don’t have a long family history of medical problems, you should consider them.
However, if you have a pre-existing condition or are genetically likely not to live into your 80s or 90s, you might want to reconsider. Remember that your annuity payments aren’t typically able to be left to a surviving partner or children. That makes them a bad bet if, for example, men in your family don’t typically live past 70.
The Rich Need Not Apply…
Annuities are attractive if you’re worried about outliving your retirement stash. However, if you’re in the opposite boat, they aren’t for you. If you managed to amass so much savings before your retirement (via hard work or luck, or a bit of both) that you wouldn’t run out if you lived to be 150, then you’re set. You can close this article right now and move on with your life. You’re going to be fine.
Take the time to calculate your retirement fund and how much it will cost you to live every year. Then figure out how many years you can live that way before the money is gone. If the money doesn’t stretch as far as you would like, consider looking into an annuity. If you have way more money than years left, then don’t bother.
…And Maybe The Poor Shouldn’t Either
This may seem counter to earlier points, but it’s important to understand that annuities are not ideal for everyone. While they can provide stability for retirees who want a guaranteed income, they also reduce financial flexibility. Once you purchase an annuity, most of your money becomes illiquid. You’ll receive scheduled payments, but accessing a large lump sum later is often difficult, restricted, or subject to steep surrender charges.
If an unexpected expense arises—such as major medical bills, urgent home repairs, or family emergencies—you may not be able to withdraw the funds you need without penalty. For people without a separate emergency fund or other accessible assets, this lack of liquidity can be risky. Ensuring you have cash reserves outside the annuity is essential before locking a significant portion of your savings into one.
Best Used in Combination
Financial experts advise that annuities should never be your only source of retirement income. If you’re considering buying one, make sure you’re not putting all your eggs into one basket. Annuities can work well as part of a larger retirement plan.
So yes, continue to invest your money in stocks, bonds, or GICs. You’ve definitely heard the term “diversify your assets” before. Adding an annuity to your retirement plans is just another way to do this. You will have to trade a bit of potential growth for some guaranteed retirement income. Only you can decide on how much of that trade-off you’re comfortable with.
When To Buy
Choosing when to buy an annuity depends on your broader financial picture—not just your age. Begin by assessing your retirement goals, expected expenses, and the income you’ll receive from savings, investments, and Social Security. If you anticipate a gap later in life, an annuity can help provide a guaranteed stream of income when you need it most. While some advisors suggest that the best age to begin taking annuity payments is between 70 and 75, you don’t have to wait until then to purchase one.
Your timeline may also depend on life expectancy and investment preferences. Those who expect a long retirement may benefit from buying a deferred annuity earlier, allowing more time for tax-deferred growth. People nearing retirement often prefer immediate annuities, which begin paying right away. Comparing these options—and evaluating your comfort with risk, liquidity, and guaranteed income—can help you determine the right time to buy.
The Last Word
There are many types of annuities, each with its own set of pros and cons. Many annuity contracts are complex and often confusing to the layman. While the promise of a guaranteed income for life might sound appealing, be sure to read the fine print of an annuity contract. You’ll see why many people find these to be bad long-term investments. If you don’t feel confident judging the potential annuity terms by yourself, recruit a more money-savvy friend or relative to help you decide.
In the end, you may be better off holding onto your investments. There are plenty of ways to continue investing your retirement funds after you’ve left the workforce. Of course, there is no one-size-fits-all solution. Whether an annuity is right for you will depend on your own financial circumstances. Regardless, retaining control over your financial future in retirement may, in the end, provide the most peace of mind.
