Annuities are insurance products that some investors use as part of their retirement plan. Yet, there is a lot of confusion about their advantages and disadvantages. Many people who would be perfectly suited for annuities end up shying away from them because the information they find online is not only confusing but also scary.
In a nutshell: We don’t recommend relying on annuities as a sole source of retirement income; however, they can be useful to enhance your retirement plan. Also, annuities come in a variety of shapes and sizes, so talk to an investment advisor who can help you figure out which one best suits your needs.
In the meantime, read on to understand some of the pros and cons of annuities.
Advantages (Pros) of Annuities
In order to understand annuities, it helps to travel back to ancient Rome …
The word annuity comes from the Latin annua, which means stipend. In ancient Rome, citizens could deposit lump sums of money into the annua. Then, they would receive annual payments as a stipend until their death. Thus, the Emperors could raise funds without raising taxes. This was a popular scheme, especially among those who stood to lose the most from tax increases.
Even soldiers were at times paid with annuities as a practical matter. And the jurist Gnaeus Domitius Annius Ulpianus created the world’s first actuarial table.1 This laid the foundation for the insurance industry as we know it.
Pro # 1 – Steady revenue stream
Given this brief history, we could call the annuity the original “life” insurance. But instead of paying upon the loss of life, an annuity pays throughout life. Some have even said that life insurance is really death insurance.2 And annuities are the real “life” insurance.
And yes, this also explains why annuities are a product of the life insurance industry. The two are both forms of insurance. Life insurance ensures care for our families should we die. And annuities “insure” care for us should we live beyond our ability to earn.
This is also why you often hear the term “deferred income” when speaking of annuities. While there are many forms, the deferred annuity reflects the original intent.3
Hence, the main benefit of an annuity is to provide a steady stream of revenue.
Pro # 2 – Income stability
A balanced retirement portfolio includes a careful mix of stocks and bonds.4 The mix protects the portfolio regardless of the economy. Stronger investments protect weaker investments.
While this traditional approach is sound, it is not the only approach. Diverse income streams such as real estate, stocks, and business and insurance products provide even more stability to retirement plans. An annuity adds further stability. Even if all other investments collapse, the annuity will pay as specified.
A fixed annuity provides guaranteed rates of return for income stability. Some use it to cushion against long-term disability or until another investment matures. Others use annuities to ensure a guaranteed income during retirement should all other investments fail.
Interested in learning more about fixed index annuities? Download our free guide, “ABCs of Fixed Annuities: A Guide to Understanding the Advantages and Disadvantages of FIAs.”
Pro #3 – Tax advantages
One of the best things about an annuity is that the contributions can grow tax-deferred. Thus, money invested can reduce your tax burden. This is especially useful if you are near on the cusp of a tax bracket.
However, if an annuity pays benefits before the age of 59½, the IRS may impose an extra 10% penalty.5 When planning an annuity, consult with an advisor who understands the tax system.
Pro #4 – True “life” insurance
Some call annuities the original “life” insurance because it protects for life. True or not, the annuity CAN protect in the event of either scenario.
Many overlook this, but death benefits are often available when buying an annuity. Naturally, there is a charge for this added protection, but in some cases, it may be worth it. Think of it as insurance for your insurance.
Disadvantages (Cons) of Annuities
Whether an annuity is called insurance or not is a matter for scholars and philosophers. This debate provides a glimpse into the disadvantages of annuities as an investment tool. This is because some of the advantages of an annuity are also disadvantages.
This may explain why there is so much confusion surrounding annuities. To understand why and understand the annuity, consider Pro # 4, which becomes Con #1.
Con #1 – Losing money
It IS possible that you may lose the money you have invested in an annuity. How so?
If you die before the annuity pays, you lose the funds invested; that is, unless you opt for the death benefit. In that event, you lose only part of the funds paid. Why?
Like any other, insurance companies are in business to make a profit. With life insurance, the insurance company is betting that you live long enough to make a profit.
The opposite is the case with an annuity. With annuities, the company is betting you die before they payout. The sooner you die after paying all premiums, the better. If this happens, the return-on-investment for you is not so great. But since you are dead …
Con #2 – Likely lower returns
Should you die before the annuity pays out, your ROI will be less than ideal. Even if you live to see the payouts, the ROI on an annuity is likely to be far lower than another investment tool. In fact, the returns of an annuity rarely match those of other investments.
Remember though, the annuity is not generally purchased as the sole investment tool. Instead, it is a tool to protect us should other investments fail. For this reason, many decide to opt out of annuities because of Con #3 …
Con #3 – The cost
Some types of annuities can be pricey. This is especially so compared to the rates of return produced by other retirement tools. Annuities can be cost-free to you, but you need to consult with a professional to decide on the best one for your situation and goals.
Yet, the biggest reason we buy an annuity is not the price, but the stability.
Many flip this matter to ask, what is the cost of the loss of all investments compared to the cost of the annuity?
Either way, the cost can be a major issue in deciding for or against an annuity. Some are funded with large, lump sums, which few people have at their disposal.
Others are funded through monthly, quarterly or annual contributions. When funded in this manner, the rates of return are further reduced. This makes the annuity even less appealing for anyone without ample disposable income.
Con #4 – Locked in
An annuity is a contract. And getting out of any contract can be difficult without knowing all the details. This is why working with a financial professional can be so advantageous. In fact, if the funding of an annuity fails, the entire sum may be lost. Even partial losses make the annuity a rather feared investment tool.
Yet, during periods of economic uncertainty, annuities thrive.6 One would think the opposite to be the case, yet it is not. Why?
During a recession, people want peace of mind. While variable annuities are not popular in weak economies, fixed annuities are. Though the fixed annuity will underperform compared to any other investment tool, it is appealing in uncertain times.7
Is an annuity a CON?
Those who do not understand annuities often think they are a rip-off, a con.8 Nothing can be further from the truth. They are simply another tool for investing. But this is not what we mean by the question.
When thinking of the cons of an annuity, such as being locked in, consider whether the con may really be a pro. For instance, being locked into an investment means commitment. The odds of continuing to fund it is strong. Thus, there is a strong likelihood that the goal of the annuity will be achieved.
The bottom line is that no investment tool is one-size-fits-all. There are pros and cons with each. Before you buy an annuity, ask a financial advisor to review your goals, plans and risk tolerance. The right advisor can help you decide the best tools for you, be that annuities or any other.
We are an independent firm helping individuals create retirement strategies using a variety of insurance products to custom suit their needs and objectives. This material is intended to provide general information to help you understand basic retirement income strategies and should not be construed as financial advice.
The information contained in this material is believed to be reliable, but accuracy and completeness cannot be guaranteed; it is not intended to be used as the sole basis for financial decisions. If you are unable to access any of the news articles and sources through the links provided in this text, please contact us to request a copy of the desired reference.
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1 Annuity Guys. “The Long Success Filled History of Deferred Annuities.” Accessed Jan. 31, 2021
2 Rebecca Shoenthal and Nupur Gambhir. Policy Genius. Oct. 27, 2020. “What Kinds of Deaths Are Not Covered by Term Life Insurance?” Accessed Jan. 31, 2021.
3 Julia Kagan and Marguerita Cheng. Investopedia. Jan. 4, 2021. “What Is an Annuity?” Accessed Jan. 31, 2021.
4 Dale Roberts. Tangerine. Oct. 25, 2019. “What’s In a Balanced Portfolio?” Accessed Jan. 31, 2021.
5 Mark P. Cussen. Investopedia. Jan. 20, 2021. “The Pros and Cons of Annuities.” Accessed Jan. 31, 2021.
6 Braden MacDonald. All Things Annuities. March 1, 2020. “Annuities in a Poor Economy.” Accessed Jan. 31, 2021.
7 Greg Depersio. Investopedia. Nov. 11, 2020. “What Are the Risks of Annuities in a Recession?” Accessed Jan. 31, 2021.
8 Multiple authors. Quora. Multiple dates. “Are Annuities a Rip-Off?” Accessed Jan. 31, 2021.
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