What Are the Risks of Purchasing Annuities?

Jennifer Wills
Feb 2
4 min read

An annuity is a contract purchased through an insurance company that guarantees income for a specific number of months or years. You receive a monthly income in an amount set when you fund the contract:

An annuity can be purchased through a lump-sum payment or a series of payments to the issuer.
The money grows tax-deferred through interest payments or investments in a market index or stock portfolio.
You receive immediate or deferred payments, depending on the timeline selected upon purchase.
The payments can last for a lifetime or a chosen duration, such as 10 years.

Reasons Why Investors Purchase Annuities

Many investors purchase annuities to help attain their financial planning goals. The most attractive features include:

1. Flexibility

The following options let you tailor an annuity to fit your financial goals and risk profile:

Purchasing one or more fixed, variable, or indexed annuities at any age.
Customizing each annuity with features such as riders, withdrawal options, and death benefits.
Transferring cash between annuity types tax-free to change your income type and match your risk tolerance.
Placing an annuity in your 401(k) or Individual Retirement Account (IRA) to consolidate your investments.

2. Tax Advantages

Annuities offer tax-deferred growth:

More of your investments can earn interest and grow.
Your earnings are taxed when you begin receiving payments.
Because you paid taxes on the principal, only your earnings are subject to income tax.

3. Reliable Income

Annuities provide a steady income stream, lasting typically for between five years and your lifetime. This feature offsets the risk of outliving your savings during retirement.

Because the principal amount is guaranteed, annuities protect against loss. Even if your selected investments underperform, your initial investment is preserved.

4. Inflation Protection

Certain types of annuities, such as indexed annuities, have returns tied to an index, such as the S&P 500, Standard and Poor’s stock market index tracking the stock performance of 500 leading companies listed on stock exchanges in the United States. This tie helps your annuity payments keep pace with inflation.

Similarly, some annuities offer a rider that accounts for cost-of-living adjustments (COLAs), periodically increasing your payments to keep pace with inflation. Increasing your purchasing power over time can hedge against rising living costs.

Risks of Purchasing Annuities

Consider the following risks before purchasing an annuity:

1. Potentially Limited Access to Information

Different levels of information available on annuities can increase the difficulty of comparing products:

Some providers offer in-depth annuity information and brochures online so you can learn the details before reaching out.
Many smaller annuity providers require you to contact them directly for information.
Working with a licensed financial professional can provide access to annuity data not publicly available, along with insight into different carriers.

2. Long Purchasing Process

The complexity of annuities and substantial amounts of funds transacted extend the purchasing process. For instance, you must share in-depth information during the purchasing process to ensure you can fund the annuity and have adequate income for living expenses. Annuity carriers must maintain suitability standards to ensure that a product is right for you.

3. Contract Complexity

The complexity of how annuities work can be confusing:

Understanding the type of annuity suitable for your financial goals and risk tolerance can take time.
Knowing how to customize an annuity to fit your needs is essential.
Talking with a licensed financial professional can help you determine whether an annuity is right for you and guide you in making a purchase.

4. Potentially High Fees

Some variable annuities, which operate more like investments and can lose money, can have higher fees than other types of annuities:

Sales commissions and investment expenses can make annuities more costly than other investments.
Administrative fees can be 1.25% annually.
Mortality and expense risk charges can be 0.15% annually.
These fees can reduce the annuity’s value.

5. Limited Liquidity

Most annuities are illiquid for a significant number of years, and typically include surrender charges for early withdrawals, often within the first 15 years. However, some annuities offer features such as a 10% free withdrawal or penalty-free withdrawals in cases of terminal illness or entering a nursing home.

6. Potential Tax Penalties

Annuities are designed to be retirement products. Therefore, withdrawing funds before age 59 ½ can result in a 10% penalty tax for early withdrawal.

7. Potentially Limited Returns

Indexed annuities offer market-linked returns, which limit your earnings if the stock market performs well. This cap restricts your returns to a specific amount, unlike most other investments.

8. Potential Loss of Purchasing Power

Converting your annuity into guaranteed lifetime payments can reduce your purchasing power over time:

Fixed annuity payments provide the same income amount at your chosen interval for the rest of your life.
Because inflation increases the cost of living, receiving a fixed annuity payment limits your purchasing power.
Adding an inflation rider to your annuity can increase your monthly income by a few percentage points annually, but reduce your initial monthly income.

9. Life Expectancy Challenges

Annuities that provide lifetime income are based on actuarial tables that estimate average life expectancy:

If you pass away earlier than anticipated, you lose out on future distributions.
Your heirs won’t receive money unless your annuity has a death benefit rider.
If they don’t receive a stepped-up cost basis for tax purposes, any gains in the annuity will be subject to capital gains tax when your heirs receive the funds.

*This information is for educational purposes only.

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