Annuities are frequently pitched to retirees as a means of providing a guaranteed income, protecting their retirement funds, and alleviating the fear of outliving their money. The reality is that they often carry high fees, very limited flexibility, and various restrictions which can make them a less attractive proposition than a traditional investment portfolio.
High Fees Reduce Retirement Income
Many annuities (particularly the variable ones) will have a number of fees attached to them. These can include insurance fees, investment management fees, administrative fees, and fees for any optional income guarantees. The total annual cost can easily exceed 3%, and that will have a negative impact on growth and therefore on retirement income.
Limited Access to Your Money
Retirees need flexibility. You may find yourself needing to access your savings for unforeseen medical expenses, a family emergency, or general changes in your financial circumstances. Many annuities have surrender charges, which can be quite expensive if you wish to withdraw your money in the first few years of the annuity. Some income annuities require you to give up your entire lump sum for the right to receive a stream of income in the future.
Inflation Can Erode Purchasing Power
A guaranteed monthly payment can provide real peace of mind but will, of course, lose purchasing power over time if it isn’t adjusted for inflation. A $3,000 guaranteed monthly payment would have the purchasing power of approximately $1,660 after 20 years at 3% inflation per annum.
Tax Disadvantages
Annuities provide tax-deferred growth, but withdrawals of earnings from non-qualified annuities are generally taxed as ordinary income rather than at the potentially lower long-term capital gains rate. Inherited annuities also generally don’t get the same step-up in cost basis as many of the traditional taxable investments.
Guarantees Come at a Cost
Insurance companies don’t offer guarantees for free. Income guarantees, downside protection, and death benefits all have the potential to reduce your returns. Some of the guarantees will also come with restrictions which will limit your access to the value of your account and your ability to invest.
A More Flexible Alternative
For many retirees, a portfolio of low-cost ETFs, bonds, and other liquid investments (held in appropriate custody and managed by a custodian or advisor) can provide income, growth potential, and greater control over their retirement assets. Risk management techniques such as hedged equities and options overlays may be used to manage market exposure but they come at a cost and with additional risk and do not guarantee protection.
The Bottom Line
Annuities can be a good fit for retirees who want guaranteed income for life. They’re not necessarily the safest or most cost-effective option for every retiree, and some will find them a useful component of a wider retirement plan.
Before you go and buy an annuity you should know precisely what you’re paying for, what you’re giving up and whether a more transparent, flexible investment option might be better to suit your circumstances.