What Are the Advantages and Disadvantages of an Annuity?

During my time as a licensed financial coach, I created complimentary, customized, confidential plans to help families become properly protected, debt-free, and financially independent. I then placed the families in programs designed to help them reach their financial goals.

For specific clients, investing in an annuity was part of their long-term plan. The company I worked for provided access to annuities that provided attractive tax-deferred growth, steady retirement income, and a death benefit.  

What an Annuity Is

An annuity is a contract between a person and an insurance company. The financial product is designed to provide a steady income stream, typically for retirement planning. This investment offers tax-deferred growth, guaranteed income, and protection against outliving savings. However, an annuity can include high fees, limited liquidity, and potentially lower returns compared to other investments.

How an Annuity Works

A person invests in an annuity through a lump sum or a series of payments. This period, known as the accumulation phase, is when the assets grow.

When the person is ready to begin receiving distributions, the contract enters the annuitization phase. They decide whether to receive the distributions in a lump sum or on a monthly, semiannual, or annual basis.

The distributions can last for a specific number of years or the rest of the person’s life. Because the money grows tax-deferred, the distributions are taxed when withdrawn or when the payments begin.

Annuity Death Benefit

Most annuities include a death benefit. If the person passes away during the accumulation phase, the company distributes the funds to the designated beneficiary or beneficiaries. Conversely, if the person passes away during the annuitization phase, the payouts are determined by the type of payments chosen.

Annuity Death Benefit Riders

Many annuity companies allow individuals to customize their contracts with death benefit riders for additional protection. For instance, a rider might entitle the beneficiary or beneficiaries to more money than they would have received under the standard death benefit.

Types of Annuities

The main types of annuities include:

• Immediate: Distributions begin within a year after the payment is made.

• Deferred: Distributions begin more than a year after the payments are made, according to the contract.

• Variable: Payments are invested into one or more subaccounts. The performance of the investments determines the distributions.

• Fixed: A minimum rate of return is guaranteed and can be reset periodically or increased annually.

• Indexed: The annuity tracks an index such as the S&P 500 and offers a capped return based on the total returns of the index. A minimum return might be included.

Advantages of Annuities

The advantages of investing in an annuity include:

• Tax-deferred growth: Because the earnings are not taxed until distribution, if the person is retired, they could be in a lower tax bracket and pay significantly less tax than when they were working.

• Potentially guaranteed rates of return: Since fixed annuities guarantee a certain percentage of the principal investment, the investment makes money.

• Regular distributions: Supplemental income during retirement can help cover living expenses.

• Potential death benefits: Most variable annuities have a death benefit equal to the net amount contributed, regardless of performance. Companies that offer enhanced death benefits record the value of the annuity’s investments on the anniversary of the contract’s start date. When the person passes away, the company pays the beneficiary or beneficiaries a death benefit equal to the highest recorded value of the annuity.  

Disadvantages of Annuities

The disadvantages of investing in an annuity include:

Expenses

Variable annuities have administrative and mortality and expense risk fees, typically 1-1.25% of the account value, to cover the costs and risks of insuring the contract. The investment fees and expense ratios vary according to how the money is invested.

Variable and fixed annuities can have surrender charges for making more withdrawals than the allowed number. The fees can be high and apply for an extended period.

Fixed and indexed annuities with benefit riders include additional fees, typically up to 1% of the contract value annually.

Returns

The money invested cannot grow as much as the stock market can because of annuity fees:

• If a person invests money in an indexed annuity, the company invests the money to mirror a specific index fund.  

• The company typically caps the gains through a participation rate.

• If the participation rate is 80%, the investments can grow by 80% of the amount the index fund grew.

• In this scenario, the person misses out on returns.

 

Taxes

A person typically pays lower taxes when investing in other products. Annuity distributions are taxed at the regular income tax rate rather than the capital gains tax rate, which is lower in many states. Therefore, investing after-tax dollars can save more in taxes than investing in an annuity.

Difficulty Exiting

A person who invests in an immediate annuity cannot get the money back or pass it on to a beneficiary. Although the individual might be able to move the funds to another annuity plan, the process typically involves fees. The company keeps any money left in the account when the person passes away.

Many annuities have surrender charges of 10% or higher during the first 6 to 8 years after investing in an annuity. Although these charges decline over time, they can significantly reduce the contract value.

Talk with a Licensed Professional

Meeting with a financial professional licensed in insurance and investments can help determine whether investing in an annuity aligns with your financial goals and should be included in your investment strategy.

*This information is for educational purposes only.