Pros and Cons of Annuities: Are They Right for Your Retirement?

If someone has ever tried to sell you an annuity, you’re not alone if you came away with more questions than answers as to how these financial products can help with your retirement. Annuities are highly complex financial products; thus, it’s essential for you to fully examine the pros and cons of any annuities you may be considering, so you can make an informed decision as to their appropriateness for you.

Start at the Beginning

When examining the pros and cons of annuities, it is important to understand the basics first. So, what exactly is an annuity? In essence, it is an insurance contract in which the insurer offers the policyholder a stream of payments over a specified timeframe in exchange for premium payments collected and invested on their behalf. These premium deposits receive interest at a rate defined in the annuity contract (often tied to performance of a specific fund or stock index), until the contract is “annuitized” and the owner begins receiving payments. This arrangement is often sold as providing “guaranteed income” for the investor. But the specific contract terms can vary widely from annuity to annuity.

Unlike securities such as stocks, bonds, shares or mutual funds, through which the buyer takes on risk in hope of their investments gaining value, annuities involve the owner transferring the risk of outliving their retirement funds to the insurance company selling the product. However, this means the annuity is only as reliable as the insurance company providing it. While it might not happen often and most state regulators provide protections in the case of such insolvencies, insurers can and do go bankrupt and/or default on payments, which can lead to annuity holders not enjoying the full benefits they were promised. It is wise to remember that transferring risk is not the same thing as eliminating it.

Another major problem with annuities is the complexity and opacity of the contracts involved. Annuity terms can be as thick as a dictionary, which may not be surprising given the precise and limited ways benefits are defined. It is only by reading the contract carefully that you’ll be able to understand what it is offered and whether that protection is right for you.

Below we look in greater depth at some of the pros and cons of annuities.

Annuities—The Pros

Despite the many drawbacks of most annuities, certain varieties can offer attractive risk-mitigation qualities. It is important to remember that some of these come with trade-offs, which we’ll go into more later:

  • Annuities promising lifetime income can be used to mitigate the risk that investors outlive their assets and end up struggling financially in their later years. However, such lifetime pay-outs are not a standard feature for all annuities, and it may actually require the purchase of a rider that likely comes with significant extra costs to enjoy this benefit.

  • With an annuity featuring guaranteed-minimum benefits, the investor mitigates the risk of falling victim to the market’s losses. In these situations, the insurer guarantees that if the annuity’s investments fail to reach minimum growth, the annuity will still calculate payments as if it had. However, the fees and costs for such features can be steep.

  • Indexed annuities generally limit the downside potential attached to securities by setting a floor on losses. However, this feature usually comes paired with a ceiling on possible gains, and other types of annuities usually require the annuitant to purchase a minimum-income or -benefit rider to enjoy this benefit.

Annuities—The Cons

Annuities are sold with all kinds of promises, but it is essential to remember that whatever reassurance annuities offer, these “upsides” are all insurance, rather than investment features. When making an investment, you accept a risk in return for a potential reward,while when you get insurance, you’re paying money to mitigate your risk.

The reality is that the disadvantages of annuities are likely to outweigh the benefits for most people’s situations. The following list details just some of these drawbacks so that you can better understand the pros and cons of annuities:

  • Annuities come wrapped in layers of fees. From the broker’s or salesperson’s fee to administrative fees to mortality & expense risk charges, these can all add up and ultimately eat into returns.

  • When you reach the annuitization (pay-out) phase of the contract, you surrender the principal you’ve deposited and thus lose ownership of the money. It irrevocably transfers to the insurer in exchange for regular income payments. This can create a challenging scenario if you either are looking to leave a legacy or desire flexibility in responding to the markets.

  • The most attractive and advantageous features of annuities—for example, lifetime pay-out, joint lifetime pay-out, and minimum income guarantees—are often optional “riders.” This means increased costs, which can easily add to the annuitant’s already-considerable annual fee burden. Inevitably, these costs limit the potential growth of the annuity. So, what might be considered an annuity “pro” becomes a “con.”

  • Annuities have “surrender charges” (which our team of counselors have seen as high as 20%), that take effect should you decide to cancel the contract and reclaim your money prior to taking a pay-out. While these charges generally decrease over time, they can limit your ability to easily modify your retirement strategy. Annuities’ inflexible contracts care little about changes in your personal or health circumstances, or if you have other unforeseen income needs. In the end, these charges are likely to lock annuitants into their contracts and ultimately fund the broker’s compensation.

  • While “variable” and “indexed” forms of annuities that tie their rates of return to the performance of securities are popular, the potential returns seen by these annuities’ owners are often capped well below actual gains. This means that even if returns are high, you will enjoy only part of that performance in your account (even before calculating fees). This makes indexed and variable annuities’ familiar sales promise of “market-like returns” a bit harder to swallow.

  • As products that provide a fixed stream of income, annuities are particularly susceptible to inflation and the rising cost of living. These factors mean each distribution from the annuity has less and less purchasing power. This is particularly troublesome for retirement savers, who often experience greater-than-average inflation, given their increased spending in categories like medical care.

It's fair to say that, in our opinion, the pros and cons of annuities need to be carefully weighed before signing a contract. In some circumstances they may be appropriate, but in our view, there are numerous pitfalls that make them more of a burden for the typical investor. The key is to have a clear plan for your retirement, if you want to understand whether an annuity is good or bad. Only by understanding what risks you face and what you need for your goals can you accurately judge when and what type of annuity makes sense. Or, if they make sense at all!

Reaching Your Retirement Goals

It is essential that you fully understand the pros and cons of annuities before tying up your money in these highly illiquid and inflexible products. Annuities are far more complex and less attractive than the average sales pitch or brochure would have you believe, so approach them carefully.

Our advice: Thoroughly read in full any annuity contracts you’re considering before signing on the dotted line, as this will inevitably help you better understand the annuity's pros and cons—and watch out for the small print. There may be better ways to work toward your retirement goals.

If you’re in need of assistance defining these goals or analyzing the pros and cons of a particular annuity relative to your retirement strategy, Fisher Investments may be able to assist. You can begin by downloading our various guides, designed to assist investors in understanding annuities (or a variety of other retirement-planning subjects). Alternatively, you can contact us directly for more information on our services and to request a meeting with our annuity or retirement-planning specialists.