Annuities represent one of the most debated financial products in retirement planning. At their core, annuities are contracts between you and an insurance company where you make either a lump-sum payment or series of payments in exchange for regular disbursements beginning either immediately or at some future date. This fundamental structure creates a unique financial instrument that can serve as both an investment vehicle and an insurance product.

The concept of annuities dates back thousands of years, with Roman soldiers receiving annua—annual payments—upon retirement. Today’s annuities have evolved into sophisticated financial products that come in various forms, each designed to address different financial needs and risk tolerances. Understanding these products requires examining both their compelling benefits and their significant drawbacks.

Types of annuities

Before diving into pros and cons, it’s essential to understand the main categories of annuities, as each type carries distinct advantages and disadvantages:

• Immediate vs. deferred annuities represent the timing distinction. Immediate annuities begin payments within a year of purchase, making them suitable for those already in or approaching retirement. Deferred annuities accumulate value over time before beginning distributions, serving as long-term retirement planning tools.
• Fixed vs. variable vs. indexed annuities differ in how returns are generated. Fixed annuities provide guaranteed returns, variable annuities tie returns to investment performance in sub-accounts, and indexed annuities offer returns based on market index performance with downside protection.
• Qualified vs. non-qualified annuities relate to tax treatment. Qualified annuities are purchased with pre-tax dollars (often within retirement accounts), while non-qualified annuities are bought with after-tax money, affecting how distributions are taxed.

The advantages

First up, let’s go over why receiving an annuity could be beneficial for you in the long run:

• Guaranteed income for life: Perhaps the most powerful advantage of annuities is their ability to provide guaranteed income that cannot be outlived. This feature addresses one of retirement’s greatest fears: running out of money. Unlike other retirement vehicles such as 401(k)s or IRAs, which can be depleted, annuities with lifetime income riders ensure payments continue regardless of market conditions or longevity.

• Tax-deferred growth: Annuities offer tax-deferred growth on earnings, meaning you don’t pay taxes on gains until you withdraw money. This deferral allows compound growth to work more effectively over time, as money that would have gone to taxes remains invested. For high earners who have maximized other tax-advantaged accounts like 401(k)s and IRAs, annuities provide an additional vehicle for tax-deferred accumulation.

• Principal protection: Many annuities offer principal protection, ensuring that your initial investment is preserved regardless of market performance. Fixed annuities guarantee both principal and a minimum interest rate, while many indexed annuities protect against market losses while allowing participation in market gains. This protection can be invaluable for conservative investors or those nearing retirement who cannot afford significant losses.

• Flexibility in payout options: Modern annuities offer numerous payout options to match individual needs and circumstances. Options include life-only payments (highest monthly income but no survivor benefits), joint-life payments (covering two people, typically spouses), and period-certain payments (guaranteeing payments for a specific number of years regardless of survival).

• Estate planning benefits: Annuities can play valuable roles in estate planning. They pass directly to named beneficiaries without going through probate, providing faster access to funds for heirs. Additionally, annuities can be structured to provide continuing income to surviving spouses or other beneficiaries, ensuring ongoing financial support.

The Disadvantages

Now for the flipside:

• High fees and costs: One of the most criticized aspects of annuities is their fee structure. Variable annuities, in particular, can carry annual fees ranging from 2% to 4% or more, including management fees, administrative fees, mortality and expense charges, and rider fees. These costs can significantly erode returns over time.

• Complexity: Modern annuities, particularly variable and indexed products, can be extraordinarily complex. Indexed annuities might have participation rates, caps, floors, and spreads that affect returns in ways that are difficult for consumers to understand. This complexity makes it challenging to compare products or understand exactly how returns are calculated.

• Limited liquidity: Annuities are designed as long-term retirement vehicles, and accessing money early can be costly and complicated. Beyond surrender charges imposed by insurance companies, withdrawals before age 59½ may trigger 10% IRS penalties on earnings. Even after surrender periods end, many annuities limit annual withdrawals to 10% of account value without penalties.

• Inflation risk: While annuities can provide guaranteed income, most fixed payment annuities don’t adjust for inflation. A payment that seems adequate today may lose significant purchasing power over a 20-30 year retirement. Some annuities offer inflation adjustments, but these typically come with lower initial payments or additional costs.

• Opportunity cost: The guaranteed returns offered by many annuities come at the cost of potentially higher returns from other investments. While a fixed annuity might guarantee 3-4% annually, a diversified stock portfolio has historically averaged 7-10% over long periods. For younger investors with long time horizons, this opportunity cost can result in significantly less wealth accumulation.
• Insurance company risk: Despite state insurance guarantee associations, annuity holders face the risk that their insurance company could fail. While guarantees typically cover annuity values up to $250,000 per company, wealthy individuals with larger annuities could face losses. Additionally, guarantee associations may not cover all benefits, and recovery could take years.