What Are the Pros and Cons of Annuities?

An annuity is a financial product that people often use for retirement planning due to the steady income stream it can provide. Annuities can offer numerous benefits, like guaranteed income, tax-deferred growth and protection against outliving savings. However, they also come with drawbacks, such as high fees, limited liquidity and potentially lower returns compared to other investments. Understanding the pros and cons of annuities is essential for making an informed decision about whether they align with your financial goals and risk tolerance.

Consider speaking with a financial advisor about your retirement planning options.

What Is an Annuity?

An annuity is a contract between you and an insurance company. You pay for the annuity through a lump sum or multiple payments, and the company grows your assets. However, growth only occurs during the accumulation period of your annuity. This is when you make payments and receive returns based on the type of annuity you have.

Once you’re ready to begin receiving payments, your annuity contract will enter the annuitization phase. You can receive payments in a variety of ways, including monthly, semi-annually, annually or in a lump sum. How you receive your money is completely up to you.

As a way to limit returns, however, annuity companies often use participation rates or rate caps. To understand participation rates, consider this example: Say the S&P 500 grows by 10% in a year, and your contract has a 60% participation rate. In this scenario, the annuity company would take that 10% growth and give you 60% of it, which would equal 6%.

Rate caps work differently. Assume the S&P 500 grows by 8% over a year, and your contract has a 5% rate cap. Your contract would receive a 5% return since the rate cap limits how much it can earn.

Understanding the Different Types of Annuities

There are three main types of annuities:

Fixed annuity. A fixed annuity guarantees a minimum rate of interest on your money, though these rates can reset annually or every few years.
Variable annuity. A variable annuity allows you to invest your money in different investment funds, including mutual funds. The size of your payments will therefore depend on how well your investments perform rather than on a fixed rate.
Indexed annuity. While an indexed annuity is technically a version of a variable annuity, it combines the benefits of both fixed and variable products. The returns you earn from an indexed annuity aren’t based on investment decisions you make. Instead, your money follows the performance of a stock market index, like the S&P 500. In this case, your money isn’t invested in the index. Rather, the annuity company will attribute your account with the returns that the index produces.

You can also choose between an immediate or a deferred annuity, which affects when you will receive your payout:

Immediate annuity. With immediate annuities, you pay the insurance company a lump sum and begin receiving payouts immediately.
Deferred annuity. With a deferred annuity, you have the option to pay a lump sum or a series of payments, but you won’t begin receiving payouts until years later. This allows your money to earn interest or appreciate in value.

What Are the Pros of Annuities?

Annuities have become increasingly popular due to their many benefits. These include:

Regular Payments

The biggest benefit of an annuity is its most basic feature: the regular payouts you receive from an insurance company. These payments can provide supplemental retirement income, which can help if you’re afraid that you might run out of money in retirement.

Keep in mind that the value and number of your annuity payments will vary depending on the type of annuity you purchase and the terms of your contract.

Tax-Deferred Contributions

Contributions to an annuity are tax-deferred. That means you can make pre-tax contributions, and you won’t owe taxes on that money until you start receiving payments.

During this period between your contributions and withdrawals, it’s possible that your money could grow significantly. This type of growth is similar to how 401(k) contributions grow.

Guaranteed Rates of Return

It's helpful to understand annuity pros and cons, as well as the different types, to see which one best suits your retirement needs.

Insurers will invest any money you put into an annuity. There’s always a certain level of risk involved when you invest money, but fixed annuities guarantee that you’ll make a certain percentage of your principal investment. That percentage can be quite low, but it still means you’ll earn more than your original investment.

Death Benefits

Variable annuities carry risk because they can result in you losing money. However, they provide an important perk: death benefits.

A death benefit is a payment that the insurance company will make to a beneficiary if you die. For a basic variable annuity, the death benefit is usually equal to the net amount you contributed to the annuity. If you buy an annuity contract worth $100,000, then the death benefit payout will likely be $100,000. It does not matter how your annuity’s investments perform.

Alternatively, you can find variable annuities with enhanced death benefits. With an enhanced benefit, the insurance company will record the value of your annuity’s investments on each anniversary of your annuity’s start date. If you die, the insurance company will pay a death benefit equal to the highest recorded value of your annuity.

For example, let’s say you have an annuity contract worth $100,000. You aggressively invest your money, and on the anniversary of your annuity’s start date, your investments are worth $125,000. Your death benefit would then be $125,000, even if your investments decline in value for the rest of your life.

What Are the Cons of Annuities?

Nothing in the financial sphere is perfect, and annuities are no exception.

Price

Variable annuities have administrative fees, as well as mortality and expense risk fees, which typically cost about 0.25% to 1.75% of your account’s value. Even the best life insurance companies charge these fees to cover both the cost and risk associated with insuring your annuity.

Investment fees and expense ratios vary, depending on how you invest. However, these fees are similar to what you would pay if you invested independently in any mutual fund. In comparison, fixed and indexed annuities are fairly cheap. Many skip the annual fees while limiting other expenses.

Companies will often allow you to customize your contract with additional benefit riders. These riders come with an additional fee, usually running between 0.25% and 1.50% of your contract value annually. However, they are completely optional.

Surrender charges are another cost that’s common for both variable and fixed annuities. These charges apply when you make more withdrawals than permitted.

Lower Returns Than Investing Directly

With an annuity, your investments will not grow at the same rate as the stock market. This is largely due to annuity fees.

Let’s say you invest in an indexed annuity. Your insurer will invest your money to mirror a specific index fund, but your insurer will likely cap your gains through a participation rate. If you have a participation rate of 80%, your investments will only grow by 80% of the index fund’s total growth. You could still make great gains if the index fund performs well, but you could also miss out on valuable returns.

Tax Implications

Another factor to consider is taxation. Contributions to a variable annuity are tax-deferred, but any withdrawals you make are taxed at your regular income tax rate, not the long-term capital gains tax rate. Because capital gains tax rates are generally lower than income tax rates, you can typically avoid paying more taxes if you invest your after-tax dollars instead of investing in an annuity.

Difficult Withdrawal

Liquidity is a major concern relating to immediate annuities. Once you contribute funds to an immediate annuity, you cannot get them back, nor can you pass them on to a beneficiary. It may be possible for you to transfer your money into another annuity plan, but doing so could also leave you subject to fees.

Additionally, your benefits disappear when you die. You cannot pass that money to a beneficiary, even if a lot of funds remain.

Annuity Mistakes That Cost You Money

One of the cons of annuities can be their fees.

Even if you know the pros and cons, there are still missteps you can make with annuities that can end up costing you:

Buying a variable annuity inside an IRA or 401(k). These accounts already provide tax-deferred growth, so the annuity’s tax deferral adds no additional benefit. What it does add is a layer of fees that you would not pay if you simply invested in mutual funds or ETFs within the same account.

Not reading the surrender schedule before signing. Most annuity contracts impose surrender charges if you withdraw more than the free withdrawal allowance during the early years of the contract, often the first five to 10 years. These charges can start as high as 7% to 10% of the withdrawal amount and decrease gradually each year. If an unexpected expense forces you to pull money out early, the surrender charge can take a significant bite out of your balance.

Choosing the most expensive income rider without comparing it to simpler alternatives. Lifetime income riders can cost 1% or more annually, and that fee applies regardless of whether you activate the rider. Before adding a rider, it is worth comparing the guaranteed withdrawal rate to what a basic systematic withdrawal plan from a low-cost portfolio could provide. In some cases, the rider’s guarantee adds meaningful protection. In others, the fee erodes your account faster than the guarantee is worth.

Focusing on hypothetical illustrations rather than the guaranteed values in the contract. An illustration shows what your account could look like under favorable assumptions; the guaranteed minimum values reflect what the insurer is actually obligated to pay. If you make a purchase decision based on the hypothetical numbers and the market underperforms, the actual outcome may fall well short of what you expected.

Naming a non-spouse beneficiary without understanding the tax consequences. A surviving spouse can typically continue the annuity contract and maintain tax deferral. A non-spouse beneficiary cannot. They must take distributions, and all accumulated gains are taxed as ordinary income. On a contract with significant growth, this can produce a large and unexpected tax bill for the heir.

Annuity vs. Other Retirement Income Strategies

While an annuity can make sense for some retirement plans, it is not the right strategy for everyone. It’s important to understand your options and how they compare to find an approach that makes sense for you and your unique situation.

The primary advantage of an annuity is that it guarantees income for a set period or for life, regardless of what the market does. If your biggest concern is running out of money, a lifetime income annuity removes that risk entirely. The trade-off is that once you hand over the premium, you generally give up access to the lump sum. Payments stop when you die unless you purchased a survivor or period-certain option.

A systematic withdrawal strategy from a diversified portfolio gives you more flexibility. You keep full control of your money, can adjust the amount you withdraw each year and leave the remaining balance to your heirs. The risk is that a sustained market decline early in retirement can deplete the portfolio faster than expected. As such, this approach works best for retirees with enough savings to withstand several years of poor returns without running short.

A bond ladder can provide predictable income over a defined period. You buy bonds that mature in consecutive years and use each maturity to fund that year’s expenses. Your principal is returned in full at each maturity date, and you receive interest along the way. The limitation is that a bond ladder does not protect against longevity risk. If you outlive the ladder, you need another income source to take over.

Delaying Social Security is often overlooked as a retirement income strategy, but it functions like a guaranteed return. Each year you delay past full retirement age increases your benefit by approximately 8%, and those higher payments continue for life with annual cost-of-living adjustments. For many, maximizing Social Security by delaying to age 70 and using savings to cover expenses in the meantime can produce more guaranteed lifetime income than purchasing an annuity with the same dollars.

Bottom Line

A couple enjoying retirement, having considered annuity pros and cons to choose the right annuity for them.

An annuity can be a strategic way to supplement your income in retirement. For some, an annuity is a good option because it can provide regular payments and tax benefits with a potential death benefit.

However, there are potential cons to keep in mind. The biggest of these is arguably the cost of an annuity. While some safer options, like fixed and indexed annuities, have lower fees, variable annuities can cost you quite a bit due to their higher potential for returns.

Retirement Planning Tips

Retirement planning is difficult to do on your own, but a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call 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.
An annuity is best for those who worry their savings won’t last them in retirement. But even if that sounds like you, an annuity might not necessarily be the best option. Before signing any contracts, consider some of these retirement planning moves for late starters.