Guide to the Pros and Cons of Annuities

By Mike Obel | AUG 30, 2023

Annuities are a polarizing topic. Many people stand by them as a solid retirement savings option that can help guarantee income streams for life or a set period of time. Others lament annuities given the fact that they charge high fees and may not pay out as much as some DIY investment options. In actuality, the various pros and cons of annuities will make them better options for some people than others. A financial advisor can help you figure out if an annuity makes sense for your retirement plans.

How Do Annuities Work?

Simply put, an annuity is a contract that you have with an insurance company. It involves making one or more payments to an insurance company in exchange for a guaranteed income stream at a later date. This makes them especially appealing retirement tools, as guaranteed income can be a big help when doing your planning.

Some annuities begin paying out sooner than others, and different annuities require you to pay into them for different amounts of time. Some annuities are paid upfront with a lump sum, whereas some have you pay into them sporadically over specific time periods. Annuities may also come with a death benefit that allows your beneficiaries to receive your payments back after you pass away.

Ultimately, annuities are a type of investment, similar to a stock or ETF. In fact, many annuities have an indexed feature that allow them to grow based on that index’s performance. Other annuities may be invested in more actively managed mutual funds, paying out based on the performance of the pool of assets. They can also function like a CD, where the annuity company offers you a specific interest rate for a certain time frame.

Either way, an annuity requires you to put in money now so that you can receive payments later. However, depending on the specifics of your contract, these payments may differ in size and period length.

What Are the Different Types of Annuities?

There are multiple types of annuities, though they all have the same end goal of providing income. Instead, they differ in how risky and potentially rewarding their return methods are.

Annuities can typically be grouped into three main categories: fixed, variable and indexed. However, within these groups are two other classes: deferred and immediate. While they all involve insurance contracts and future payouts, there are some key differences to note.

As its name suggests, a fixed annuity will simply earn returns based on an interest rate you’re given by the insurance company. Like a CD, the longer you lock your money up, the better the rate you’ll receive. This makes fixed annuities fairly low-risk, making them a good idea if you’re fairly risk-averse. For instance, if you’re planning to retire within the next decade or two, this could be a good option.

A variable annuity functions similarly, though instead of a set interest rate, the money you pay in is invested in a mutual fund of your choosing. Like any investment, companies usually offer a selection of risky to safer funds, with the return potential usually being the inverse. So if the fund or funds you select perform well, you’ll receive more growth for your future payments. However, there always remains the chance that subpar market conditions could significantly eat into your annuit’s growth.

An indexed annuity attempts to marry the two annuity types above. They feature both an indexed account and fixed account, which you can decide how to divide your money between. The funds in the indexed account will often be paired with the performance of a reliable market index, like the S&P 500. The fixed account, as you’d expect, earns based on a set interest rate. However, indexed returns are usually capped, though floors that eliminate any chance of you losing funds are common with most indexed contracts.

Once you choose the type of annuity you want, you’ll need to decide what kind of payment schedule you want. By far the most common option is a deferred annuity, as these feature the same tax breaks as a 401(k) or traditional IRA. This makes them great options for those who are still years from needing the income. That way, you’ll have a steady income stream starting at a later date, such as during retirement.

Immediate annuities, on the other hand, begin paying out usually within a year of you opening it. You can even start receiving payments right away, though most companies will allow you to defer up to 12 months. These may be better for those who are already in retirement or who have a lump sum that they’d like to annuitize immediately.

Pros of Annuities

Annuities can be a good idea because they have the flexibility to provide guaranteed income for a predetermined period of time or for life. If you pay an amount into an annuity, you’ll be able to count on that money rolling in either monthly, quarterly or annually. Depending on the specifics of your situation, you can choose between either payments for life or a period certain. You may even be able to pass it down to your beneficiaries if you die.

There are also specific advantages when it comes to certain types of annuities. Fixed annuities, for example, have the added benefit of being safe. You’ll be able to count on solid, stable growth on your investment. In periods of market volatility, this takes away considerable stress. Variable annuities may pay out more at certain times, but could pay out less in others or even lose you money. Indexed annuities are beneficial due to their ability to combine the benefits of both fixed and variable contracts.

Deferred annuities and immediate annuities are different, but the positives and negatives of each aren’t as well defined. It really depends on your preferences for when you want to receive your payouts. Deferred annuities may allow you to pay in during your working years when you don’t have a lump sum yet. Conversely, with an immediate annuity, you can make a payment with a large retirement account balance or other windfall of cash.

Cons of Annuities

Many people are quite critical of annuities because of the hefty fees they often charge. These include financial professional sales commissions associated with annuities, which can be a tough pill to swallow if you don’t have a ton in retirement assets yet.

One clear downside to a variable annuity is that you may end up losing money in the event of a market downturn. Similarly, a fixed annuity won’t give you much in extra returns when the markets are booming. It may be a better idea to have full control over how your money is invested, instead of leaving it up to the terms outlined in the annuity.

While every annuity differs in its specific terms, a potential downside of a deferred annuity is that you could be left in the red if you pass away before your annuity has paid out. If you don’t have a death benefit that specifies the beneficiaries who will continue to receive your annuity payments, the insurance company could keep the money that they’ve yet to pay out.

This is a note for all retirement accounts, not just annuities, but make sure you can hold off on withdrawing any funds you deposit into your annuity until at least age 59.5. If you can't, the IRS could hit you with a harsh 10% penalty.

Bottom Line

Annuities, like any other financial instrument or product, have upsides and downsides. There are many different types of annuities, so just because one isn’t right for you doesn’t mean that another won’t be a good fit. You should think about looking into an annuity especially if you’ve received a lump sum of cash and are looking to turn it into regular payments for an extended period of time. However, an annuity can also be a good way to create a steady stream of income into retirement. Just make sure you’re familiar with the potential benefits and drawbacks before investing in an annuity.

Tips for Investing for Retirement

• Investing for retirement can be a complex process. With so many different boxes to check, it’s often hard to keep your ducks in a row. A financial advisor can help you make sense of it all. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors in your area, and you can have free introductory calls with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Investing and saving for retirement is an important part of your overall financial health. SmartAsset has tons of free online resources to help you meet your retirement goals. For example, check out our free retirement calculator today.

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