Annuities have real tradeoffs, and whether one makes sense depends on your situation
Annuities are not inherently bad, but they are not right for everyone. An annuity is a contract with an insurance company where you give them a lump sum or make regular payments, and they promise to pay you income — either when ready or at a future date. The appeal is predictable income you cannot outlive. The drawback is that your money becomes locked into that contract, often with steep fees and penalties if you need to withdraw early.
Whether an annuity is a good choice depends on three things: whether you need may provide income in retirement, whether you can afford to have that money locked away, and whether the specific annuity's costs are reasonable. A person with a pension and Social Security might not need one. A person with substantial savings and no other income source might benefit from one. The same person buying the wrong type of annuity at the wrong price will regret it.
Key Takeaways
- Annuities lock your money into a contract in exchange for may provide income, which works well if you need that income and can afford to lose access to the principal.
- Surrender charges — penalties for withdrawing early — can be 5 to 10 percent or higher and last 5 to 10 years, making annuities unsuitable if you might need the money soon.
- Fees vary widely between annuities, and some products charge 2 to 3 percent annually in addition to surrender charges, which can significantly reduce your returns.
- Fixed annuities offer predictable payments but low returns; variable annuities tie returns to market performance but carry more risk and higher fees.
- An annuity bought at age 50 with money you might need within 10 years is a poor fit; one bought at 65 with money you plan to leave untouched is often a better match.
When surrender charges make annuities expensive to exit
The biggest complaint about annuities is the surrender charge — a penalty you pay if you withdraw money beyond a small annual allowance before the contract period ends. These charges typically run 5 to 10 percent of your withdrawal amount and can last 5 to 10 years. If you put $100,000 into an annuity with a 7 percent surrender charge and need that money in year three, you lose $7,000 when ready.
Surrender charges exist because the insurance company is betting on keeping your money for a set period. They use that certainty to lock in the rate they promise you. But this structure means an annuity is a poor fit if there is any chance you will need the principal within the surrender period. Life circumstances change — a health crisis, a job loss, a family emergency — and an annuity can trap you into paying a steep price to access your own money.
Some annuities allow you to withdraw a small percentage each year without penalty, often 10 percent. That is not the same as having access to your money. If you need 20 percent in year two, you still pay a surrender charge on the excess.
How fees reduce the income an annuity actually pays you
Beyond surrender charges, annuities carry ongoing fees that reduce your returns. A fixed annuity — one that pays a set rate — typically has lower fees, often 0.5 to 1 percent annually, though some charge nothing visible because the insurance company builds the cost into the rate they offer you. A variable annuity — one where your returns depend on how underlying investments perform — often charges 1 to 3 percent per year in management and insurance fees alone.
Those percentages sound small until you calculate them over time. On a $200,000 annuity, a 2 percent annual fee is $4,000 per year. Over 20 years, that compounds. You are also paying for features you may not use — like a death benefit rider or a long-term care rider — that add to the cost.
The problem is that annuity fees are often buried in the contract and not clearly compared to alternatives. A person could buy a straightforward fixed annuity from a low-cost provider and pay very little, or buy a complex variable annuity with multiple riders and pay substantially more for similar income. Shopping around matters enormously.
Fixed annuities offer safety but low returns
A fixed annuity pays you a rate set when you buy the contract. That rate is may provide — the insurance company bears the investment risk, not you. If you buy a fixed annuity paying 4 percent, you get 4 percent regardless of what happens in the stock market. For someone who cannot tolerate market risk and needs predictable income, this is the appeal.
The tradeoff is that the rate is usually low. Insurance companies are conservative investors, and they price in their own costs and profit. A fixed annuity rate is typically lower than what you might earn from a diversified portfolio of stocks and bonds over the same period. You are paying for safety and certainty with lower returns.
Fixed annuities also do not protect you from inflation. If you buy a fixed annuity paying $2,000 per month, that payment stays $2,000 per month for life. In 20 years, inflation will have reduced what that money can buy. Some fixed annuities offer inflation riders that increase your payment over time, but these cost extra and reduce your starting payment.
Variable annuities tie returns to markets but add complexity and cost
A variable annuity lets you choose how your money is invested — typically among mutual fund-like options — and your income depends on how those investments perform. If the market does well, your annuity does well. If the market falls, your annuity falls. You bear the investment risk, not the insurance company.
Variable annuities appeal to people who believe they can earn higher returns by investing in stocks and bonds than they would get from a fixed annuity. The problem is the cost. Variable annuities routinely charge 2 to 3 percent annually in fees, which means you need your investments to outperform a fixed annuity by at least that much just to break even. Many do not.
Variable annuities also come with optional riders — guarantees that your income will not fall below a certain level, or that your heirs will receive a minimum amount — that sound protective but add significant cost. A variable annuity with multiple riders can easily cost 3 to 4 percent per year, making it hard to justify unless you have a specific reason to believe the extra features are worth it.
when ready annuities versus deferred annuities: timing matters
An when ready annuity is one you buy with a lump sum and begin receiving payments right away, usually within a month. You give the insurance company $200,000, and they pay you $1,000 per month for life. This is straightforward and works well for someone who has just retired and wants to convert savings into income.
A deferred annuity is one you buy now but do not begin receiving payments until a future date — perhaps 10 or 20 years from now. You pay in over time or as a lump sum, the money grows (either at a fixed rate or tied to market performance), and then at a set date you begin receiving income. Deferred annuities appeal to people who want to lock in a future income stream but do not need the money yet.
The distinction matters because a deferred annuity locks your money away for longer, which means surrender charges last longer and the risk that you will need the money before the income phase begins is higher. An when ready annuity is simpler: you know what you are getting and when, and there is less time for circumstances to change.
Who should consider an annuity and who should avoid one
An annuity makes sense if you have a substantial amount of money you do not expect to need for living expenses, you want may provide income you cannot outlive, and you have already maxed out other tax-advantaged retirement accounts like 401(k)s and IRAs. A person with $500,000 in savings, a modest pension, and Social Security might use an annuity to cover discretionary spending and have peace of mind that the income will not stop.
An annuity is a poor fit if you are young and might need access to the money, if you have high-yield savings or money market accounts available, if you distrust insurance companies or dislike illiquid investments, or if you cannot afford to lose access to the principal for 5 to 10 years. A person in their 50s with uncertain job prospects should not lock money into an annuity. A person in their 70s with stable income and a long life expectancy might benefit from one.
The worst scenario is buying an annuity you do not understand, paying high fees without realizing it, and then discovering you need the money and cannot access it without a steep penalty. This happens often enough that financial advisors recommend getting a second opinion before buying, especially if the annuity is complex or the fees are not clearly stated.
How to compare annuities if you decide to buy one
If you are considering an annuity, compare at least three quotes from different insurance companies. Ask for the exact monthly or annual payment you will receive, the surrender charge schedule (how much you lose if you withdraw in year one, year two, and so on), and all annual fees expressed as a percentage and as a dollar amount. Do not accept vague language like "competitive rates" — ask for numbers.
For a fixed annuity, the main variables are the interest rate, the surrender charge period and amount, and any optional riders. For a variable annuity, also ask for the underlying fund expense ratios, the insurance and administration fees, and the cost of any riders. A straightforward fixed annuity from a reputable company often outperforms a complex variable annuity with multiple riders.
Consider whether you need the annuity at all. If you have a pension and Social Security covering your basic expenses, and you have savings you can draw from, an annuity may not add much value. If you have no pension and Social Security alone is not enough, an annuity might be worth the cost. The math depends on your specific situation.
Frequently Asked Questions
Can I get my money back from an annuity if I change my mind?
Most states have a "free look" period of 10 to 30 days after you buy an annuity during which you can return it and get your money back with no penalty. After that period ends, you are subject to the surrender charge if you withdraw. Read the contract to find the exact free look period for your annuity.
What happens to my annuity if the insurance company fails?
Insurance companies are regulated by state insurance commissioners, and most states have a guaranty fund that protects annuity holders if an insurer becomes insolvent. The protection limit varies by state but is typically $100,000 to $250,000 per person per company. Buying from a large, well-established insurer reduces this risk further.
Is an annuity better than keeping money in a savings account?
An annuity pays more than a savings account if interest rates are low, but it locks your money away and charges fees. If you can get 4 percent in a high-yield savings account and an annuity also pays 4 percent but charges 1 percent in fees, the savings account is better because you can access your money. The annuity only wins if the rate is significantly higher and you do not need the money.
Do I have to buy an annuity through my employer?
No. Employer-sponsored annuities exist, but you can also buy an annuity directly from an insurance company or through a financial advisor. Shop around — rates and fees vary widely, and buying independently often gives you more choice and potentially lower costs than an employer plan.
What is the difference between an annuity and a pension?
A pension is income your employer provides in retirement, funded by the employer. An annuity is a contract you buy with your own money. If you have a pension, you may not need an annuity. If you do not have a pension, an annuity is one way to create may provide income in retirement, though it is not the only way.