5 Things You Should Know About Annuities

You can access that money only as a lifetime income stream — there’s no option for extra withdrawals — so be careful before tying up too much of your savings in an income annuity. It’s important to keep other funds accessible for emergencies and other expenses.

One strategy when deciding how much to put into an immediate annuity is to add up your regular expenses in retirement, subtract any guaranteed sources of income you already have (such as Social Security or a pension) and consider buying an annuity to fill some or all of the gap.

If you don’t need the annuity to supplement your retirement income at present but expect to you will in the future, you could opt for a deferred-income annuity that lets you invest a lump sum now but put off starting payouts.

One advantage: The payments are much bigger. For example, if our 65-year-old man invests his $100,000 in a deferred-income annuity that kicks in at age 75, he’d get $1,401 per month for the remainder of his life. One big caveat: If he dies before then, he’ll get nothing.

You can get a version of a deferred-income annuity that guarantees you or your heirs will receive at least as much as you initially invested, in return for lower payouts ($1,237 per month, in the investment example above).

Sometimes called “longevity insurance,” deferred-income annuities can be a way to guard against longevity risk — the prospect of running out of money because you live longer than you expect. However, some people are reluctant to spend so much money for a payout they may not receive for decades, if at all.

“It’s a very long-term commitment,” says Spencer Look, associate director of retirement studies for Morningstar’s Center for Retirement and Policy Studies.

3. You need to know what you want

Some annuities do let you take withdrawals when you choose rather than in a locked income stream. But if you withdraw more than a certain amount in the early years, you may have to pay a surrender charge, and you may lose some guarantees. Some of these annuities are more like investment vehicles with tax benefits than a way to get guaranteed retirement income.

For example, fixed-rate annuities offer a guaranteed rate of interest for a set period, such as five years. Taxes on earnings are deferred until you take withdrawals.

Variable annuities let you invest in mutual fund-like accounts and defer taxes on earnings until you withdraw the money. Patrick Carney, a certified financial planner and manager of adviser services with Rodgers & Associates in Lancaster, Pennsylvania, says a variable annuity may make sense for someone with significant assets outside of a retirement plan who has a large tax bill each year for interest and dividends.

For an additional fee, you can add a guaranteed lifetime withdrawal benefit that lets you withdraw up to a certain amount from your annuity every year, no matter what happens to your investments. But, unlike with an income annuity, you aren’t locked into these annual withdrawals.

These guarantees might be attractive for someone who wants to invest in mutual funds for the long-term but is worried about losing money in the early years of retirement. A market downturn in the first few years of taking withdrawals increases the potential for running out of money much more than a downturn down the road, a concept known as “sequence risk.”

“This is one of the few ways to protect yourself from sequence risk for money that is invested in the equity markets,” says Mark Cortazzo, a certified financial planner with Wealth Enhancement group in Parsippany, New Jersey.

But these guaranteed-withdrawal riders are complex and typically come with restrictions. For example, a rider might guarantee that the pot available to withdraw money from will be based on the highest value your investments reach, even if the actual value subsequently falls. But it might also limit much you can withdraw each year to, say, 5.75 percent of that guaranteed value. If you find you need to take more in a given year, that could void the guarantee.

Fixed-index annuities let you benefit from a portion of a stock index’s gains but minimize downside. They typically tie their performance to an index, such as the S&P 500, but you may only get a portion of the index’s price increase — say, up to a 7 percent cap. If the index goes up 5 percent, you get 5 percent; if it goes up 10 percent, or 20 percent, you get 7 percent. However, if the index goes down, you lose nothing. 

“There are a lot of trade-offs and nuances in these products,” Look says.

4. Lessening risk adds complexity and cost

The more you try to hedge against risks like a bear market or a big tax bill, the more complicated the annuity — and the more you’ll pay for it.

The way the fees are assessed varies by type of annuity. With variable annuities, you invest in mutual fund-like accounts and the insurer takes a portion of your account balance in fees. Those fees are spelled out in the prospectus, and they can be expensive compared with other types of investments. The average annual fees for variable annuities without additional features were 2.084 percent in 2022, according to Morningstar. Adding an income rider brings the average cost to 3.145 percent, two to three times the typical fees for a 401(k) plan.

Fixed-index annuities don’t have fees spelled out separately, but that doesn’t mean the product is free. The insurer promises you a portion of the return of a certain index, such as the S&P 500. But the insurer does not invest your money in that index; they invest in something else — usually bonds and derivatives — and make money if those investments do better than your fixed rate on the index.

“For example, if bonds are yielding 6 percent per year, the insurer might take 1.5 percent off the top to cover commissions and administrative expenses [for the annuity] and earn a profit,” Look says.

Both variable and fixed-index annuities can also have hefty surrender charges if you withdraw more than a certain amount in the first few years. For example, you’ll typically have to pay a surrender charge of 7 percent of your withdrawal if you cash out the annuity in the first year. The charge gradually decreases each year you own the annuity and usually disappears after a set number of years, but “some fixed-index annuities have longer and higher surrender charges,” Carney says.

5. The seller — and the salesperson — matter

Monthly payouts for income annuities can vary a lot by company. If you’re buying from a broker or adviser, it helps to work with one who deals with several insurers and can show you the best rates for your age and type of payout. There are also comparison websites that provide price quotes from several insurers for immediate and deferred-income annuities.

Remember: You’re counting on this income to continue for the rest of your life, so you want the company behind it to be stable and strong. Carney recommends looking for an insurer with a financial-strength rating of A or better, as determined by established raters such as Fitch Ratings, AM Best, Moody’s and S & P Global.

Variable annuities are not as easy to compare. The investments and fees must be spelled out in the prospectus, but they can vary significantly, and it gets much more complicated when analyzing guaranteed withdrawal riders. Fees are based on terms that may be defined differently from company to company. Providers may also differ on how investment gains are measured and how often measurements are made.

Fixed-index annuities can be even more complicated. Performance can be based on different indexes and limited by complex calculations or caps. If you don’t understand exactly what you are paying for, ask questions or consider a different type of investment.

Not all salespeople can offer a full range of options. Someone with an insurance license can sell income and fixed-index annuities, but selling variable annuities or mutual funds requires a securities license. You may be getting only part of the story if you work with a salesperson who sells only one product and may not explain your investment alternatives.

“Annuities have historically offered some of the highest commissions for salespeople,” which can incentivize salespeople to push certain products, Maurer says. “I recommend simply asking the person recommending the product how they are compensated.”