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Annuities are generally seen as safe investments that can provide guaranteed income in retirement. Some annuities can also be passed to a beneficiary down the line. But like any investment, annuities aren't entirely risk-free. Fees could diminish your returns, and your money isn't insured by the Federal Deposit Insurance Corp. (FDIC). Understanding how an annuity works can help you decide if it's compatible with your risk tolerance and financial goals.
What Is an Annuity?
An annuity is a contract you purchase from an insurance company, bank, mutual fund company or brokerage firm. Some annuities will invest your premiums, where they'll grow on a tax-deferred basis for a specific amount of time. Other annuities provide periodic income payments for a set time period, which may cover you until death.
Here's a snapshot of the three main types of annuities:
- Fixed annuities: These low-risk annuities offer fixed payments and a guaranteed rate of return. They're predictable, but payments may not keep pace with inflation.
- Variable annuities: Your premiums can be invested in assets like stocks, bonds, money market funds and mutual funds. Returns will depend on investment performance. Variable annuities eventually transition to a payout period, at which point you'll receive guaranteed minimum payments.
- Indexed annuities: These annuities offer both a guaranteed return and a return that's tied to a stock market index such as the S&P 500. Think of them as a cross between a fixed annuity and a variable annuity.
Annuities can be immediate—meaning that they start providing payments right away—or deferred. With a deferred annuity, payments begin at a future date.
Can You Lose Money in an Annuity?
While annuities are typically considered safe, it's always possible to lose money when investing. Fees, which we'll unpack shortly, can eat into your overall returns. What's more, your funds are not insured by the FDIC. It's wise to weigh the pros and cons of an annuity before buying one.
Benefits of Annuities
They Can Help You Save for Retirement
Annuities can unlock a guaranteed stream of income in retirement—sometimes for life. That could provide peace of mind if you're worried about outliving your nest egg. Even if you opt for variable or indexed annuities, which invest your premiums, you're still saving for your future.
The size of your returns will depend on the type of annuity you choose and how much you put into it (minus any fees). That's why annuities are often one part of a larger retirement savings plan. Other sources of retirement income may include:
- Money you have in a 401(k) or individual retirement account (IRA)
- Social Security benefits
- Funds you've saved in a brokerage account
- Accumulated cash value you may have in a permanent life insurance policy
- Pensions, if applicable
They Can Provide Diversification
Staying diversified is an important part of investing because it can help spread out the risk. If all your money is in stocks, for example, you could suffer major losses if the market turns, especially if you're heavily invested in a particular industry. Diversification means investing in a variety of different asset classes and sectors. Having some annuities in the mix can expand your financial portfolio and diversify your retirement income.
Some Annuities Provide a Death Benefit
Certain annuities have a death benefit provision. This allows you to leave a portion of your annuity payment to a beneficiary for a set number of years. Couples can also go with a joint-life, also called joint and survivor, annuity that provides higher payments when both people are still alive. If one person passes away, the survivor's payment will decrease.
Risks of Annuities
Fees
Annuities can include the following fees:
- Agent commissions: These typically range anywhere from 1% to 8%, according to annuity provider Canvas. You might be able to find a commission-free annuity online or through a financial advisor.
- Administrative fees: This can be an annual fee that's charged as a flat amount or as a percentage of your account value.
- Surrender penalties: With a variable annuity, you cannot withdraw funds or sell the annuity during the surrender period. This is usually six to eight years.
- Early withdrawal fees: Tapping your annuity before age 59½ will usually result in a 10% penalty.
- Mutual fund fees: You may run into mutual fund fees if your annuity is invested in mutual funds.
- Mortality and expense risk fees: This charge, which is usually about 1.25% each year, goes to the insurer for assuming the risk of selling you the annuity.
Returns May Lag Behind Other Investments
Annuities are considered low-risk assets, but returns may not be as robust as other investments. Fixed annuities also provide a guaranteed return that doesn't change. That money could be worth less and less as time goes on, thanks to inflation. Investing in the stock market, on the other hand, can have different results in the long term. Average annual returns measured by the S&P 500 are around 10%.
Annuities Are Not FDIC-Insured
Virtually all bank and credit union deposit accounts are insured for up to $250,000 per depositor, per insured institution for each account category. This offers protection if the bank or credit union fails. Funds invested through most brokerage firms are insured for up to $500,000 by the Securities Investor Protection Corp. (SIPC) in the event the brokerage fails.
Annuities are insured by state guaranty associations, and coverage levels can vary from one state to the next. Most cover at least $250,000 per customer, per company, according to the National Organization of Life & Health Insurance Guaranty Associations—but certain types of annuities may be excluded. You can check with your state's guaranty association to clarify what's covered.
Should You Buy an Annuity?
Whether or not annuities are right for you depends on your financial situation and long-term goals. They might make sense if you want to:
- Secure guaranteed income payments in retirement
- Expand your investment portfolio
- Leave a death benefit to a beneficiary
- Diversify your retirement income
- Find a low-risk investment
Just keep in mind that most annuities come with fees, which can vary depending on the provider. Returns can also trail behind investments that carry more risk.
What Is Better Than an Annuity for Retirement?
Some retirement accounts allow you to build your nest egg while enjoying some tax perks along the way. That may include:
- 401(k): This employer-sponsored retirement plan allows for pretax contributions, reducing your taxable income—and you won't pay taxes until you make withdrawals in retirement. Required minimum distributions (RMDs) and early withdrawal penalties apply.
- Traditional IRA: This type of IRA may allow you to take a tax deduction on your contributions, though you can't contribute quite as much as you can with a 401(k). Early withdrawal fees apply. And like a 401(k), you must start taking RMDs at age 73.
- Roth IRA: A Roth IRA is funded with after-tax dollars. That means there are no RMDs or early withdrawal penalties for your contributions. To withdraw investment earnings tax- and penalty-free, you'll have to be 59½ or older and have the account for at least five years.
The Bottom Line
Annuities are low-risk investments that may fit into your long-term financial plan, especially if you want guaranteed income payments in retirement. But there are some downsides to consider. Potential fees, for example, can be a sticking point for some investors. Still, using an annuity alongside other retirement savings accounts could be a good strategy.