When you hit retirement, one of the big questions is: how do you convert your savings into a steady stream of income? For many, this shift from "save, save, save" to “spend, spend, spend” is a tough mental adjustment. That is where products like annuities come in, promising guaranteed income to ease the transition. And while they sound appealing on the surface, annuities often come with significant downsides that make me hesitate to recommend them. Let’s break it down.
What Is an Annuity?
An annuity is a financial product sold by insurance companies. Essentially, you give a lump sum of money to the company, and in return, they promise some type of guaranteed return and/or a steady stream of income. This can last for a set number of years or even for the rest of your life, depending on the type of annuity.
At its core, the appeal of an annuity is simple: you don’t have to worry about the stock market, the economy, or running out of money. It’s similar to having a pension—steady, reliable income you can count on.
Why Do Annuities Sound So Good?
Annuities are often marketed as a safe, stress-free way to retire. The pitch goes something like this: "The stock market is unpredictable, the global economy could collapse, and politicians in Washington can’t be trusted. Put your money in our annuity, and you’ll never have to worry about any of that again."
For retirees who feel overwhelmed by managing their investments or are worried about outliving their money, this sales pitch can be incredibly compelling. But there’s a lot more to the story.
The Downsides of Annuities
While annuities can provide peace of mind, they come with several significant drawbacks:
1. Low Rates of Return
Insurance companies are in the business of making money, so they structure annuities to ensure they can pay your guaranteed income while still turning a healthy profit. That means the returns on your investment are typically much lower than what you might earn by keeping your money in a diversified portfolio of stocks and bonds. Unless you live an exceptionally long life, you’re unlikely to maximize your money’s potential.
2. Limited or No Inheritance
Many annuities offer lifetime income payments, but there’s a catch: when you die, the payments stop. That means there’s often little or nothing left for your heirs. If leaving an inheritance is important to you, this could be a major downside.
3. High Fees and Commissions
Annuities are notorious for their high fees. Commissions for the agents selling them can range from a few percentage points to as high as 7-10% of the amount invested. For example, if you put $300,000 into an annuity, the agent might earn 7% ($21,000) just from selling you the policy. While there's nothing necessarily wrong with commissions, many annuity purchasers are unaware what the commission is (or that there is a commission at all!). These high commissions can incentivize aggressive sales tactics, leading people to buy annuities they don’t fully understand or need.
Additionally, many annuities have ongoing fees, which can further eat into your returns over time.
4. Surrender Penalties
If you decide an annuity isn’t right for you after signing up, getting out can be costly. Most annuities come with surrender penalties if you withdraw your money within the first few years. These penalties can be as high as 8-10% in the first year, making it difficult to change course if you realize the annuity isn’t meeting your needs.
When Annuities Might Make Sense
Despite these drawbacks, there are a few scenarios where an annuity could be a reasonable choice:
Replacing Bonds: For a small portion of your portfolio, an annuity might serve as a substitute for bonds, providing a fixed income stream with minimal risk.
Low Risk Tolerance: If you’re extremely risk-averse and the idea of market fluctuations keeps you up at night, an annuity could provide the peace of mind you need to stay on track with your financial plan. For example, you might allocate 40% of your money to a fixed annuity and 60% to growth-oriented investments.
Tax Deferral: High-income individuals who have maxed out other retirement accounts might use an annuity for its tax-deferred growth. However, this benefit often isn’t as advantageous as it seems when compared to a regular taxable investment account.
Why I Rarely Recommend Annuities
For most people, the downsides of annuities outweigh the benefits. The high fees, low returns, and lack of flexibility make them a less-than-ideal choice in many cases. Instead, I typically recommend strategies like the guardrails withdrawal approach, which allows retirees to generate income, grow their nest egg, and maintain flexibility.
For example, with the guardrails strategy, you can adapt your withdrawals based on market performance, giving you the potential to keep 15-30% more of your savings compared to locking your money into an annuity. Plus, you retain the ability to leave an inheritance and adjust your financial plan as needed.
Bottom Line
Annuities can provide peace of mind, but that comfort often comes at a steep cost. Before committing to an annuity, it’s crucial to fully understand the fees, restrictions, and long-term implications. In many cases, there are better ways to create reliable income in retirement without sacrificing flexibility or growth potential.
If you’re curious about alternative strategies, stay tuned—I’ll be diving into the guardrails withdrawal method in an upcoming blog post. It’s a powerful approach that gives retirees more control and confidence in their financial future.