6 Reasons Savers Are Skittish About Annuities

According to LIMRA research, only about 1 in 10 workplace retirement plans offer an annuity option, but more than 4 in 10 plan sponsors say they intend to do so or are actively considering it. The momentum is due in part to the SECURE Act, a 2019 federal law that relaxed regulations governing the purchase of annuities through individual retirement accounts (IRAs) and 401(k) plans.

Whatever annuity you are considering, read the fine print in the contract and, if possible, consult a trusted financial adviser to help you understand the terms.

The problem: Little or no inflation protection

“The majority of annuities out there provide a fixed nominal benefit that is not indexed to CPI,” Look says, referring to the Consumer Price Index, the federal government’s main gauge for inflation. “So over time, the purchasing power will decrease.”

What to consider: You can buy inflation-adjusted or inflation-protected annuities that boost payouts to reflect increases in the cost of living — but only up to a point. Many cap these increases, so your payments can still lose buying power if the inflation rate exceeds the cap.

Other types of annuities might offer an inflation protection rider, which adjusts the monthly payment each year based on a formula that takes the CPI into account. There’s a trade-off, though: Your base payments will likely be lower than if you had bought an annuity without the inflation rider.

The problem: Commissions and fees

Annuities can be expensive. There might be administrative and maintenance fees (assessed as a percentage of the total value of the annuity or by flat rate), charges for underwriting and fund management, and surrender fees for taking money out beyond your monthly payment. Riders for things like inflation protection or passing on the annuity to an heir will also cost extra.

Commissions vary as well and are typically higher for more complex annuities. The commission on a 10-year fixed-index annuity ranges from 6 percent to 8 percent, compared to 1 percent to 3 percent for a single premium immediate annuity, according to Annuity.org, a financial news and information site.

Some fixed annuities are marketed as charging no fees, but that’s typically because the provider is, in effect, collecting fees in the form of lower returns, Look says.

What to consider: Always ask the sales agent for a comprehensive breakdown of fees, expenses and commissions and carefully check cost-related provisions in the contract. If anything is still confusing or unclear, consider having a financial professional review the information for you.

Watch out for high-pressure sales tactics, such as an agent urging you to act quickly on a supposedly limited-time deal or pushing you to switch from one type of annuity to another. This could signal that an agent or company is putting their interests ahead of yours, seeking to sell you on a high-commission plan that might not best meet your needs. 

“If you are working with an insurance agent and they are pushing one specific product, that’s probably a red flag,” Look says. “For those who are able to, working with an adviser is a good step to understand their needs.”

The problem: Your money is tied up

Buying an annuity can mean locking a large chunk of your retirement assets into an income plan for an extended period, rather than having them available to draw down at your own pace (or use for an emergency). That isn’t for everyone.

“When people are reaching retirement age, they have more retirement wealth than at any time in the rest of their life,” William Gale, a senior fellow in economic studies at the Brookings Institution, said at an April 18 forum in Washington, D.C., on the youngest boomers’ retirement prospects. “It’s probably not the optimal time for them to think about outliving those resources.”

If you decide to cancel or take money out of an annuity before it matures (typically a period of six to eight years), you could face steep fees. Surrender changes can be as high as 7 percent of the total value of your annuity, according to Annuity.org. If you are under age 59½, you may owe the IRS a 10 percent penalty as well.

What to consider: Annuity contracts should lay out the terms and fees associated with the “surrender period.” The penalty typically declines year by year and goes away once the annuity matures.

Some contracts grant emergency withdrawals without surrender charges in certain situations, such as a nursing home admission or terminal illness, but these “crisis waivers” often come with their own fees.  Weigh the various costs and consider how comfortable you are limiting liquidity in your later years.

The problem: You might not live long

A basic life annuity generally offers the largest monthly payments, and they last as long as you do. That’s a pretty good deal if you live for 20-plus years in retirement, which is not unusual — you’ll probably get considerably more money back than you put in. But if you die within a few years, you’ll have only received a fraction of your investment.

What to consider: Many annuities do offer a death benefit, which allows you to add a beneficiary, typically a spouse or child, who will inherit all or part of your monthly payments when you pass away.

“A huge majority of annuities that are sold for income purposes have some sort of feature for a beneficiary,” Look says. “So that concern is relatively easily to overcome.” 

The caveat is that opting for a death benefit usually means smaller payments than if you choose a plan that’s contingent only on your own lifespan.

The problem: Limited growth

Annuities are designed to offer a predictable income stream when you retire. But the returns you’ll receive may pale in comparison to what you’d get if you invested the money in the stock market instead.

What to consider: When weighing an annuity, think about your risk tolerance. Different annuities offer different opportunities to grow your assets, and different levels of risk.

For example, fixed annuities offer a predictable rate of return, while fixed index annuities offer the possibility of more growth by tying returns to the performance of a market index, such as the S&P 500. But returns on a fixed index annuity are often capped and may end up being lower than the actual gains in the market index it tracks.

“They are a hybrid product, but they are not going to outpace major stock markets,” Look says. Some fixed index annuities offer higher “teaser rates” in the early years of the contract that decline over time. These annuities are “very, very complex,” he warns. 

“The important thing for investors to focus on, in consultation with their financial professional, is whether the protected accumulation, lifetime income and other features available through annuities make sense relative to costs and opportunities for each individual financial plan,” Buckingham says. “There really is no one-size-fits-all solution.”