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By 2040, about one in five Americans will be age 65 or older, up from roughly one in eight in 2000—and from less than one in 20 in 1920. As the population ages, more people are seeking financial products that can provide stability in retirement.
Annuities are an increasinly popular solution, but their complexity and fees can make them easy to misuse. Here’s what you should know before committing your savings, including some of the most common pitfalls and how to avoid them.
Key Takeaways
- Annuities have many potential pitfalls due to their complexity and inflexibility, like realizing too late that early withdrawals trigger costly surrender fees.
- Before you buy, learn each type of annuity’s features, fees, and restrictions, and compare providers for reliability and service.
- The right annuity should fit seamlessly into your broader retirement plan, matching your income timing needs, risk tolerance, and survival benefit goals.
- Consider consulting a fiduciary advisor who can help you navigate annuity complexity and choose one that supports your long-term goals.
An Overview of Annuities
Typically used in retirement planning, annuities are financial products sold by insurance companies to provide reliable income. In exchange for a lump sum or series of premium payments, the insurer makes regular payouts back to you over a predetermined period.
Both the timing and consistency of your payouts can vary depending on the type of annuity you choose. The primary axes on which they fall include:
- Immediate vs. deferred: Immediate annuities pay out soon after purchase, typically within one month to a year. In contrast, deferred annuities may not reach their payout phase for many years.
- Fixed vs. variable: Fixed annuities invest your premiums in conservative assets, allowing them to provide a guaranteed payment amount. Variable annuities are tied to investments with market risk, so their payments can fluctuate depending on the performance of the underlying assets.
Common Annuity Pitfalls
1. Underestimating Complexity
Annuities can be overwhelmingly complex, with countless moving parts and decisions to make. It’s easy to overlook just how many details matter—payout timing and return profiles are just the beginning. You also need to determine whether you want features like inflation protection, death benefits, or long-term care riders.
Each choice can dramatically affect your future income and flexibility. If you rush into an annuity without understanding these issues, you risk locking yourself into a long-term contract that doesn’t fit your needs or goals, which could significantly impact your income and flexibility in retirement.
2. Failing To Understand Costs
Annuities come with a multitude of fees that can undermine your returns. These may include annual management fees, administrative charges, and recurring expenses for any optional features or riders you add. If you don’t pay close attention to the often opaque fee schedules before committing, you could end up with a lower stream of fixed income than you expected.
One of the most significant potential expenses is the surrender fee: a steep penalty for withdrawing some or all of your funds before a set surrender period. These charges typically start high and gradually decrease over time.
Note:
For example, an 8% penalty in your first year might decrease by 1% annually, meaning you could lose a substantial portion of your funds—and the returns they would have generated—if you withdraw money in the first decade.
3. Choosing the Wrong Product or Provider
Each type of annuity offers different payout structures, features, and risk-return profiles, so it’s surprisingly easy to end up with a product that doesn’t fit your needs. Before committing, consider your financial situation and broader retirement plan to ensure your chosen annuity aligns with your risk tolerance, other income sources, and timing needs.
Choosing the right provider is just as important since your future income depends on the company’s ability to honor its commitments. Research each provider’s financial strength using independent rating agencies, like AM Best, and review customer feedback to gauge the typical experience and quality of support.
Tip
Reviews often skew negative because dissatisfied customers are more likely to leave comments. Focus on recurring patterns over individual complaints.
4. Overlooking Inflation Protection
Annuity payments are often at least partially fixed, which means their purchasing power may erode over time. You can help mitigate this risk with inflation-protected annuities (IPA), which increase your payments annually to help them keep up with rising prices.
However, inflation protection doesn’t always index your payments to the actual inflation rate. Many contracts boost payments by a set percentage each year, which may fall short if inflation spikes. Additionally, adding this feature isn’t free and may result in lower initial payouts.
5. Misunderstanding Tax Implications
Annuities grow tax-deferred, so you don’t pay taxes on your investment returns while your money remains in the account. However, the way you fund your account dictates the tax treatment of your premiums and eventual payouts.
A qualified annuity is funded with pre-tax dollars. This means your premiums may be tax-deductible, but payouts and withdrawals will be fully taxable as ordinary income.
A nonqualified annuity is funded with post-tax dollars. Premiums aren’t tax-deductible, but only the earnings portion of your payouts and withdrawals is taxable. The portion that represents your initial contributions comes out tax-free.
Important
When you inherit an annuity, you don’t receive a step-up in cost basis like you do with stocks or mutual funds. As a result, beneficiaries of annuities generally owe income tax on the same amount of earnings as the original policyholder.
6. Neglecting Survivor Benefits
Failing to plan for what happens to your annuity after you pass away is one of the most costly mistakes you can make. If your contract doesn’t include a death benefit or joint-life payout feature, your remaining annuity balance could go to the insurance company instead of supporting your loved ones.
Adding these riders may cost you, but they offer potentially invaluable protection for your family’s financial future. If you expect your spouse or other dependents to continue relying on this income after you’re gone, review your contract carefully to ensure its survivor benefits align with your goals.
7. Misinterpreting Guarantees and Sales Promises
It’s easy to misunderstand what “guaranteed” means when it comes to annuities. Many products promise guaranteed income, but conditions apply, or the actual meaning is more nuanced. For example, “guaranteed” might only refer to the insurer’s ability to make payments—not to their amount.
Be wary of sales pitches that sound too good to be true, especially those promising high returns with little risk. Some agents work on commission or represent one company, which can influence which products they recommend and how aggressively they promote them.
Strategies for Making Informed Annuity Decisions
Conduct Thorough Research
Before purchasing an annuity, take the time to conduct thorough due diligence. Examine each contract carefully, paying close attention to fees, payout terms, and restrictions.
Important
Consider how each option fits into your broader retirement strategy. Someone seeking guaranteed lifetime income will need a very different product from someone trying to bridge a temporary gap until Social Security benefits begin.
Don’t overlook the importance of the insurer’s financial strength either. Annuities are long-term contracts, and your income is only as reliable as your provider’s ability to remain solvent for its duration.
Consult Financial Advisors
Annuities are notoriously complex products. Despite their growing popularity, only around 19% of American adults are able to define them correctly. A qualified financial advisor can help you navigate potential contracts and ensure you choose a product that fits your retirement plan.
Look for advisors who specialize in retirement planning and have experience with annuities. Don’t hesitate to take advantage of free initial consultations to gauge their expertise, compensation structure, and communication style before committing.
Tip
Whenever possible, seek annuity advice from a fiduciary, who is legally required to put your best interest first, rather than pursuing commissions or personal gain.
Consider Diversification
Even if you avoid all their common pitfalls, relying solely on annuities for retirement income can limit your portfolio’s growth potential and make it vulnerable to inflation. Annuities can be a valuable part of your fixed-income approach, but they work best as one piece of a comprehensive retirement strategy.
While guaranteed income streams can offer peace of mind, it’s essential to balance them with growth investments, like stocks and mutual funds. Diversifying your retirement income sources this way can help you maintain stability while addressing inflation and longevity risks.
What Are the Risks Associated With Variable Annuities?
Variable annuities carry market risk, so your returns can fluctuate with the performance of underlying investments and potentially result in losses. They also tend to have higher fees and expenses, which can further erode your returns.
How Can I Determine the Right Type of Annuity for My Retirement Plan?
Start by assessing your income timing needs, risk tolerance, and other retirement savings to identify any gaps an annuity could fill. Consider working with a financial advisor who can help you evaluate your strategy and navigate complex contracts.
What Should I Look for in a Financial Advisor When Considering Annuities?
Look for a fiduciary who is legally obligated to act in your best interest rather, rather than sell products for commissions. Ideally, choose someone who specializes in retirement planning and has proven experience with annuities.
The Bottom Line
Annuities can offer valuable benefits in retirement, but their complexity, costs, and inflexibility make it easy to stumble into costly pitfalls. Before choosing an annuity, research your options, understand all fees and restrictions, and compare the financial strength and customer service of different providers.
Make sure any annuity you consider fits into your broader retirement strategy, including your income needs, risk tolerance, and goals for your loved ones. A qualified financial advisor can help you avoid common mistakes.
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