There is a good chance that annuities have come up in any retirement discussion or when you sat down with a financial advisor. And, for good reason. Annuities are often promoted to guarantee a steady income and financial security. Despite this, annuities can seem too good to be true, especially when they claim to provide lifetime income.
However, before you sign anything, take a step back and ask yourself: Can you really trust an annuity? It depends on what kind you’re considering, who’s selling it, and if it fits your financial goals. Read on to learn what annuities are, their pros and cons, and what to watch out for before you invest.
What Exactly is an Annuity, Stripped of the Jargon?
At their core, annuities are contracts between you and an insurance company. It turns a lump sum of savings (or a series of payments over time) into a steady, predictable income stream. Think of it as a bridge between your accumulated wealth and your retirement needs.
Although annuities sound straightforward, there are many types, each with its own characteristics.
Immediate annuities.
Typically, within one year of paying the insurance company a lump sum, you begin receiving regular income payments from an immediate annuity (also known as a single premium immediate annuity or SPIA). Those who have already retired and need income right away often choose this option. Some Immediate annuities can begin soon after the paperwork is done and money deposited.
Deferred annuities.
Unlike immediate annuities, deferred annuities allow you to grow your money before receiving payments. Whether you contribute a lump sum or make periodic payments, the money accumulates interest or investment gains. Typically, payments begin when you retire. Before income starts to flow, this “deferral” period allows for potential growth.
Fixed annuities.
This is the most straightforward type. For a set period of time, the insurance company will pay a fixed interest rate on your contributions, and your payments will also be fixed and predictable. As a result, your income stream will remain stable and predictable.
Variable annuities.
There is more risk associated with these because they are more complex. You contribute money to various sub-accounts (similar to mutual funds), and the value of your annuity and your eventual income payments will fluctuate based on the performance of these underlying investments. Despite their growth potential, they are also subject to market risks.
Indexed annuities (Fixed Indexed Annuities or FIAs).
These annuities attempt to strike a balance between the two. To protect against market losses, they often have a “floor” (a minimum guaranteed return, frequently 0%) linked to a specific stock market index, like the S&P 500. In addition, they usually restrict your earnings, so you won’t earn everything the market does.
The Allure of the Annuity: Why Do People Choose Them?
A primary reason people buy annuities is the promise of guaranteed income. An annuity can feel like a lifeline in an age when defined-benefit pensions are largely gone and retirees worry about outliving their savings. Why? It functions like a “personal pension” that delivers consistent cash flow no matter what happens in the markets or how long you live.
Annuities offer several benefits to individuals.
Lifetime income.
Annuity contracts often ensure payments for life, or even for the joint lives of you and your spouse. The assurance that essentials like housing, food, and healthcare will continue to be covered for as long as you live can bring immense peace of mind.
Tax deferral.
In a deferred annuity, earnings are tax-deferred. You don’t have to pay taxes on investment gains until you withdraw the money in retirement. This may be an appealing option if you are still working and in a higher tax bracket or anticipate being in a lower bracket later.
Protection from market losses.
Annuities, particularly fixed annuities and indexed annuities, protect against stock market declines. Your principal and interest rate are guaranteed whenever you purchase a fixed annuity. Although gains on an indexed annuity might be capped, your principal is typically protected.
Protected assets.
In states like Florida and Texas, annuities and cash-value life insurance policies are fully protected from creditors and bankruptcy courts, largely to protect retirees. Some states offer limited exemptions or none at all; others offer no protection at all. Whether an annuity is protected depends on specific terms, such as qualifying events and payment amounts.
Death benefits/estate planning.
In some annuities, you can designate a beneficiary to receive the remaining value or a specified payout if you pass away before receiving all payments. This is an additional layer of protection for your loved ones.
It all sounds pretty compelling, doesn’t it? A secure, predictable income stream, tax advantages, market protection, and possibly even asset protection can provide financial peace of mind. Nonetheless, this is precisely where trust becomes crucial.
Where the Trust Can Falter: The Downsides and Red Flags of Annuities
A retirement annuity is not inherently a “bad” investment. In certain circumstances, they can be handy for specific individuals. However, they are undeniably complex, often come with significant costs, and, more importantly, are not always sold with your best interests in mind. Here are some common red flags and pitfalls you should know before signing any contract;
Exorbitant fees.
This is the biggest concern in many annuities, particularly variable and some indexed ones. Over time, multiple layers of fees can significantly erode your returns. Some of these include:
- Mortality & Expense (M&E) charges. Annuities have insurance components that charge these fees.
- Administrative fees. The fee for managing the annuity contract.
- Investment management fees. Variable annuities have the following underlying investment options.
- Rider costs. An additional fee may be charged for optional features or guarantees (e.g., guaranteed lifetime withdrawal benefits).
- Surrender charges. This is perhaps the most painful. You can be penalized up to 10% of your initial investment if you withdraw your money before a specified period (the surrender period), which is often 7-10 years.
Long lock-up periods (lack of liquidity).
A surrender charge is imposed as a direct consequence of long lockup periods. It often takes years, sometimes a decade or even longer, before you can access your principal without incurring hefty penalties. Your money can effectively be “stuck” if your life circumstances change unexpectedly — you require emergency funds, encounter an unforeseen expense, or simply decide you no longer want annuities.
Overly complicated terms and riders.
There is no denying that annuity contracts can be dense and filled with financial jargon. A rider is an optional feature that can be added to an annuity (for example, guaranteed income floors, enhanced death benefits). Despite their apparent appeal, these riders are often expensive and require a meticulous fine print reading to understand their actual value, limitations, and how they interact with the core contract. There’s much to misunderstand regarding what you’re receiving and giving up.
Aggressive and misleading sales tactics.
Trust is perhaps the most critical issue. After all, it is common for commission-based agents to sell annuities. Since the agent’s income is directly related to the product’s sale, it potentially incentivizes them to place their paycheck before finding the best solution for your financial well-being. High-pressure sales pitches are often targeted at seniors, along with exaggerated promises of returns and downplayed explanations of fees and liquidity restrictions. You should be wary of advisors who push you to decide immediately.
Lack of flexibility.
Unlike other investment vehicles that allow easy access to your money, annuities often provide limited flexibility once your money is committed. If you decide to deviate from this income stream, it can be difficult or costly.
The Annuity Interview: Crucial Questions to Ask Before You Buy
Before you ever sign on the dotted line, arm yourself with knowledge. To start, identify the questions you should ask yourself and any financial advisor you may be considering annuitizing with. Their answers to your annuity questions and willingness to provide clear, unbiased information will indicate their trustworthiness.
“What precise type of annuity is this, and how does it truly work?”
Find out whether it’s fixed, variable, or indexed and how the returns, risks, and payments are calculated.
“Provide a complete, itemized breakdown of ALL fees.”
This is non-negotiable. All fees should be listed in writing, including commissions, annual expenses, riders’ costs, and, most importantly, surrender charges. Also, understand the percentages and timeframes that apply.
“What is the surrender period, and what are the penalties for early withdrawal?”
Understand how long your money is locked up for, as well as the financial consequences if you need to access it early due to an emergency or change in plans.
“If there are any guarantees, how are they backed?”
Be wary of verbal assurances. If you want a guarantee of income, a minimum return, or protection of your principal, ask for written documentation. The insurance company’s financial strength (see next point) should be considered.
“What is the financial strength rating of the issuing insurance company?”
Annuity payments are only as secure as the insurance company that backs them. As such, check their ratings with independent agencies like A.M. Best, Moody’s, or Standard & Poor’s. A strong rating indicates greater financial stability.
“How does this annuity truly fit into my overall retirement plan and financial strategy?”
An annuity should never be considered a stand-alone product. Ideally, it should serve a specific, well-defined purpose within your financial plan. Don’t trust an advisor if he or she can’t explain this clearly.
“What are the specific state laws regarding creditor protection for this annuity in my state of residence?”
For asset protection, get written documentation describing the specific level of security offered and any conditions (e.g., qualifying events, payment amounts, limits).
Who Might Actually Benefit from an Annuity?
Although annuities can be complicated and have potential pitfalls, they can benefit specific individuals.
- Retirement-age individuals who value guaranteed income. An annuity might be a good choice if your primary goal is to generate a predictable, lifelong income stream to cover essential expenses and reduce anxiety about outliving your money.
- Those seeking a degree of market security. With indexed annuities, you can get a sense of security while protecting a portion of your principal from market drops.
- People without a traditional pension. Without a pension, an annuity can provide a baseline of essential income.
- Individuals with high net worth who have maxed out their other retirement accounts. It is possible to accumulate wealth through tax-deferred annuities without contributing to 401(k)s, IRAs, or other tax-favored accounts.
- Those living in states with strong creditor protections for annuities. Annuities, particularly those sold in states like Florida or Texas that offer significant, unconditional protection from creditors, might be a compelling asset protection tool for those in those states.
Who Should Proceed with Extreme Caution (or Avoid Annuities Altogether)?
Not everyone is suited to annuities. It is especially important to be cautious if:
- You’re under 59½. If you withdraw money before this age, you will incur surrender charges and a 10% IRS penalty on top of your regular income tax.
- Despite multiple explanations, you don’t fully understand the product. After a thorough explanation, do not proceed with an annuity if the terms, fees, and mechanics remain unclear. Often, complex products are misunderstood, resulting in buyer’s remorse.
- It is sold for a high commission. Be highly skeptical whenever an advisor seems overly enthusiastic about an annuity and doesn’t fully disclose their compensation. You should seek out a fee-only fiduciary.
- Your retirement income is already sufficient and reliable. Pensions, Social Security, and other diversified investments can provide enough guaranteed income to cover essential expenses without locking up more money in illiquid, high-fee annuities.
- You expect to need access to your money during the short- to medium-term. Because annuities have long surrender periods, they are not suitable for funds you might need for emergencies, large purchases, or unforeseen expenses.
- You live in a state with limited or no protection for annuity creditors. Other asset protection strategies might be more effective in states that do not provide robust, unconditional protection for annuities.
How to Approach Annuities the Smart Way: “Trust, But Verify”
Do you believe an annuity might fit your retirement plan well? If that’s the case, here are some steps you can take with caution and intelligence and ways to protect yourself from annuity scams.
- Seek a fiduciary advisor. This is paramount. You should work with a financial advisor legally bound to act solely in your best interests. Unlike commission-based fiduciaries, fees-only fiduciaries typically charge hourly or flat fees.
- Comparison shop relentlessly. Never buy the first annuity you’re offered. Instead, compare quotes from multiple reputable insurance companies. Take a close look at each company’s contracts, fees, riders, and guarantees.
- Understand the “worst-case scenario.” Ask about what will happen if you withdraw money prematurely, die sooner than expected, or the market performs poorly (for variable or indexed annuities).
- Demand a plain-English summary. You should request a clear, concise overview of the contract, its terms, and all associated fees in a language you can easily understand from the advisor or insurer. It would be a significant red flag if they were unwilling or unable to do so.
- Resist high-pressure sales tactics. Unethical advisors insist on immediate signing, emphasize “limited-time offers,” or use scare tactics, such as “rates are about to change!” In reality, a sound financial decision will remain sound tomorrow. So, be patient, do your due diligence, and don’t rush anything.
Conclusion: Trust, But Verify
Annuities can be a valuable retirement planning tool if you understand what you’re buying and how it fits into your financial life. Despite the real benefits offered by annuities, they are often complicated, expensive, and tend to be oversold. It’s not whether annuities are good or bad — it’s whether the annuity you’re considering makes sense for you.
Whenever you feel something is off, get a second opinion from someone not tied to a commission. Remember that once you sign, it’s hard to take back.
So, can you trust an annuity? In short, yes. But only after doing your homework, asking the right questions, and confirming that it truly is in your best interest.
FAQs
What’s the main appeal of an annuity for retirees?
Guaranteed income is the biggest draw, especially for life. Many retirees worry about outliving their savings, especially if they do not have a traditional pension. No matter how long you live or how the market performs, annuities can provide a predictable, consistent stream of income that can cover your essential living expenses.
How do I know if an annuity salesperson is trustworthy?
You should be cautious of anyone who;
- You are urged to “buy now” before rates change or are subjected to high-pressure sales tactics.
- Does not mention fees, risks, or surrender charges, but only emphasizes the benefits.
- Suggests putting a substantial portion of your savings into an annuity.
- Doesn’t have a clear explanation of the product in simple terms.
- They are not fully transparent about their compensation (commissions).
It is always a good idea to seek the advice of a fiduciary advisor. As a result, they are legally obligated to act in your best interests, not just those suitable for you. Unlike commission-based financial planners, fee-only planners are fiduciaries.
Is there a way for me to verify the financial strength of the insurance company offering an annuity?
You will receive them if the insurer can afford your payments. So, review ratings from the following independent agencies;
- A.M. Best
- Moody’s
- Standard & Poor’s (S&P)
- Fitch Ratings
A high rating (e.g., A or better) indicates a healthy financial position.
How can I buy an annuity safely and smartly?
- Get the help of a fiduciary advisor. This step is necessary to ensure the best advice possible.
- Shop around. Consult multiple, highly-rated insurance companies.
- Be sure to read the fine print. Read it thoroughly, not just skim it. Understanding the entire contract, including all terms, disclosures, and conditions, is essential.
- Be aware of the worst-case scenario. Understand what happens if you need money early, if market conditions or your life circumstances change.
- Don’t rush. Don’t feel pressured to buy. It is okay to wait a day or two before making a sound financial decision. Walk away if someone insists on an immediate sale.
- Get a second opinion. In case of doubt, consult another independent, fee-only financial planner for an unbiased review.
Image Credit: Andrea Piacquadio; Pexels
