Annuities are often recommended by advisors as good options for retirees, and in some cases, they can be appropriate. The positive features of annuities include the potential for lifelong income, regardless of how long you live, and guaranteed death benefits for heirs. Annuities can also offer tax-deferred growth.
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However, annuities come with a number of drawbacks, and it’s important that you fully understand what you’re getting into before you decide to buy one. While an annuity can be the right choice for some investors, there are a number of reasons you might actually be better off avoiding an annuity.
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They’re Expensive
One of the primary drawbacks to annuities is that they are generally more expensive than other investment options. Annuities are contracts with insurance companies, meaning they carry an insurance component. This adds fees and expenses, like mortality and expense charges and administration of contract maintenance fees.
But annuities can also have a host of other fees, ranging from add-on rider benefits to contingent deferred sales charges and subaccount expenses, such as the fees to manage the investment portion of an annuity.
Not all annuities will have all of these fees, but all will have at least some of them. According to the Washington State Office of the Insurance Commissioner, annuity expenses can be 3% or more per year.
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You Lose Investment Control
When you buy an annuity, you hand over investment control to an insurance company. While fixed annuities are generally invested in Treasury securities, variable annuities often have the freedom to invest in a wide variety of stocks, bonds or other securities.
If you understand how markets work and can be successful managing your own portfolio — even if you simply invest in an S&P 500 index fund — you can accomplish your goals much more inexpensively than if you buy an annuity. You’ll also have the flexibility to pick and choose your own investments based on your own personal objectives, risk tolerance and changing financial situation.
They Could Be Hard To Sell
Annuities are notorious for having steep surrender charges, also known as “contingent deferred sales charges.” These typically decline from year to year but can start as high as 6% or more and last for seven years or more.
For example, according to MassMutual, surrender fees might start at 6% in year one and decline to 5% in year two, 4% in year three, 3% in year four, 2% in year five and 1% in year six. While an annuity is meant to be a long-term investment and a surrender charge may help keep you invested, it also removes your flexibility to access your money if your circumstances change.
You Might Not Need the Income
Although annuities come in many forms, their ultimate aim is to “annuitize,” which means to convert the value of the contract into an income stream. However, in exchange for this guarantee of income, you’re paying fees to the insurance company.
If you already anticipate having enough income from other sources by the time you retire, then you don’t really need an annuity.
They Carry Inflation Risk
Just like all bonds and fixed income products, annuities carry inflation risk. This is the risk that the fixed, regular income stream you receive from your annuity will become less and less valuable over the years as inflation continues to rise.
In other words, while receiving $5,000 in monthly income might be more than enough to cover your expenses right now, 20 years down the road, that $5,000 won’t buy you nearly as much in goods and services. If you’re relying on the fixed income stream from an annuity to fund your entire retirement, you’ll have to factor in the loss of purchasing power as the years go by.
Who Do Annuities Work For, and Who Should Avoid Them?
Annuities have significant pros and cons. For some investors, the pros outweigh the cons, while others should simply avoid annuities when planning for retirement. Here are the main differences.
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Annuities can work for investors over 59 1/2 who are looking for stable, guaranteed lifelong income and who take a hands-off approach to their investments. They could work for investors who have maxed out their other retirement plans, such as IRAs and 401(k) plans, and are looking to make additional contributions to a tax-deferred account, as annuities have no contribution limits.
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Annuities should be avoided by investors who prefer the freedom and liquidity offered by managing their own investments and who want to reduce or even eliminate fees. They should be avoided by younger investors who can get snagged by both surrender charges and the IRS 10% penalty for annuity withdrawals before age 59 1/2.
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This article originally appeared on GOBankingRates.com: 5 Reasons Avoiding an Annuity Is a Smart Move for Your Retirement
