Annuities for Retirement: Are They a Wise Choice?

Key Takeaways:

  • The three primary types of annuities are fixed, indexed and variable.
  • While some indexed annuities allow you to participate in the market with less downside, performance caps can limit the upside.
  • Annuities are already tax-deferred, meaning there is no additional tax benefit for having an annuity in your IRA.

Whether you have already retired or are in the process of planning, you may have seen numerous advertisements suggesting you buy an annuity for retirement. And it probably sounds great. Tax-sheltered growth until you need the money, then a guaranteed income stream! Market-like returns with less risk! Big benefits for your loved ones! You might even think it sounds too good to be true, and we believe, in most cases, it is.

If you have taken the time to read the fine print in an annuity’s thick prospectus, it often becomes clear most annuities are complex, costly and restrictive.

So What Are Annuities?

An annuity is, simply, longevity insurance. When you buy an annuity contract, you give the insurance company a premium—in either one lump sum or multiple installments—in return for an income stream that may last your lifetime or a set period of time.

An investor can choose either a deferred annuity or an immediate annuity. In a deferred annuity, the payouts are deferred to begin at a later time. In an immediate annuity, the lump sum is converted into a stream of future payouts that could begin in less than a year. There are three primary types of annuities—fixed, indexed and variable—and the process of converting a lump sum payment into a regular income stream is called annuitization.

Fixed annuities typically guarantee—upon annuitization—a fixed or minimum rate of return over a set time period, similar to a certificate of deposit.

Indexed annuities offer a rate of return based on a specific market benchmark like the S&P 500. But unlike index funds, indexed annuities often cap a portion of the market return to the owner. Also, some annuities are based on benchmarks that don’t include dividends in their calculations, which can further limit the annuity’s total return.

Variable annuities allow owners to invest the premium in subaccounts like mutual funds. They may offer a minimum rate of return that is guaranteed to the owner even if the underlying assets underperform. But complex fees and other costs can offset the benefits.

The common sales pitch is that annuities provide certainty: The insurer is guaranteeing lifetime income (or income over a certain period). Other investment products don’t offer guaranteed income, so it is a differentiating factor for annuities. But that differentiating factor is often misunderstood and it doesn’t mean these products are right for you.

Pitfalls of Annuities

Variable annuities often have complex fees that could severely erode compound growth potential. Over time, these direct and indirect fees can cause annuity investments to significantly lag returns from more direct investments in the underlying securities (in the case of variable annuities) or indexes (in the case of indexed annuities).

Variable annuities may also carry stiff exit penalties, called surrender charges. By the time you figure out the annuity is a raw deal, leaving is usually costly. Typical surrender charges usually start at a higher amount, such as 7% of the total contract value, and then decline gradually over time.

An additional pitfall of variable annuities is they don’t offer the same protection against loss as other annuities. While investors can purchase insurance “riders” to seek protection against loss for a variable annuity, these riders can be expensive.

Annuities may also have several barriers to growth. These include participation and index rates, performance floors and caps and different crediting methods. Participation rates mean you only keep a portion of any market returns.

Caps limit your return each year. So, if the market is up 20% one year and you have a 10% cap on annual returns, you’ll only receive a 10% return and miss out on the remaining 10% market return. Similarly, indexed annuities are often sold as protecting the investor from downside loss in bear markets. But in exchange for this protection, they will often cap returns. Floors and caps may suggest steadier returns over time, which could be attractive for your retirement account. However, there can be significant trade-offs in the form of growth.

Inflation is a silent threat that can be overlooked by investors, especially when purchasing an annuity as part of a retirement plan. Many annuity contracts don’t factor inflation into payments or terms. If your annuity income isn’t adjusted for inflation, the payments you receive during retirement could lose purchasing power over time. Many investors need increasing purchasing power to sustain them in retirement, as health care and other costs can continue to rise. So, an annuity may not be all that helpful when it comes to meeting these increasing financial needs.

Annuities and the Provider

With both variable and equity-indexed annuities, the provider (typically an insurance company) earns money either through variable annuities’ fees or by capturing the difference between the market’s return and your capped return in an indexed annuity.

Further, to get the much-advertised “guaranteed” income, you must annuitize the contract, which requires you to turn your entire principal over to the provider. In other words, they take ownership of your money but owe you a certain amount of income over time.

When Do You Need Retirement Income?

If you require cash flow immediately in retirement, an annuity may not make the most sense. Intuitively, contracts that you would use to begin payments immediately are called immediate annuities. When considering an immediate annuity, keep in mind it is usually an irrevocable decision. You are handing over your savings in exchange for a stream of payments. Before you buy, consider whether your goals are limited to retirement funding or if they are broader. If broader (passing funds on to heirs, large one-time expenses, savings, etc.), this option may not make sense for you as you may be able to easily modify your income stream for one-time expenses or to pass on funds to heirs without paying for an additional rider.

If you aren’t taking income immediately, you are likely purchasing a deferred annuity, designed to grow in value until you convert it into an income stream later. Deferred annuities can be costly, restrictive, potentially tax-inefficient and low yielding. Deferred annuities include fixed, variable and indexed annuities. All three have a period called the accumulation period in which your funds are invested. The idea is that the funds grow tax-deferred and then, when you are in need of regular income, you turn them into a stream of payments.

Annuities and Taxes

In most cases, the tax efficiency of annuities is largely overstated.[i] While funds in an annuity aren’t subject to income or capital gains taxes, they aren’t necessarily tax-free. (Incidentally, this is why the SEC cautions against purchasing annuities in IRAs: Since IRAs are already tax-deferred, annuities provide no additional tax benefit.[ii] Annuity funds are tax-deferred. When you withdraw money, you must pay ordinary income tax on any amounts above what you put in. Compared to a taxable investment account, the income tax rates on your annuity income could be higher than what you would have paid without an annuity.

Annuity Considerations

If you are considering annuities to supplement your retirement income, asking the following questions may prove helpful:

  • What broad type of annuity is this? Fixed, variable or indexed?
  • How is my performance determined? Are there caps, limits or fees?
  • How is the insurance company making money on this product?
  • What if I decide I want out? Are there surrender fees? How long will they apply?

Many investors are attracted to annuities because they think retirement income sources like Social Security benefits, employer-sponsored retirement accounts and retirement savings may not provide sufficient income required in retirement. Before investing in an annuity, make sure you have an understanding of how the contract works and how it will fit into your retirement goals. You may find that traditional investments like stocks and bonds are a more efficient way to meet your retirement goals. If you would like to learn more about annuities, request our Annuity Insights guide today.

[i]The contents of this webpage should not be construed as tax advice. Please contact your tax professional.

[ii]Source: Securities and Exchange Commission, as of 11/12/2019. “Variable Annuities: What You Should Know,” page 4.

target icon

Download an Educational Guide


Get industry-leading investment analysis

Distribution Icon

Contact an Experienced Professional


Explore how to invest your money and get investing ideas to match your goals.

lightbulb icon

Sign up for our Newsletter


"Our research team tracks the markets and helps people break through the clutter."

Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns.
Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations.