What Are the Biggest Disadvantages of Annuities?

Any annuity can be disadvantageous if it doesn’t match your goals

Reviewed by Marguerita Cheng

Annuities can protect you from various types of financial risk, but that protection comes at a cost. You will pay fees for the annuity and will not have as much upside potential as you would with certain investments. 

The trade-offs can be worth it for the peace of mind of guaranteed lifelong income that annuities provide. Still, annuities do have disadvantages, and if you’re thinking about buying an annuity, it’s important to know what the possible downsides are.

Key Takeaways

• There are several types of annuities, annuity issuers, and annuity products.
• Any annuity can be beneficial or not, depending on whether it matches your financial goals. Those looking at annuities should fully understand both their benefits and drawbacks.
• Annuity holders will pay fees up-front and sacrifice potential returns possibly earned elsewhere, but in return an annuity provides certain guarantees and safety nets, such as guaranteed income for life.

Annuities Can Be Complex

Annuities come in many varieties, and that fact alone is enough to create a lot of confusion among consumers. Should you buy a single premium immediate annuity? A deferred payment annuity that’s variable? A fixed indexed annuity? It can be overwhelming to unpack the different features of each annuity, especially when one insurance company’s fixed-indexed annuity will have different characteristics than another’s. 

There’s also a whole new vocabulary you’ll need to learn—“mortality and expense fee,” “joint life payout,” “subaccount,” “surrender fee,” “participation rate,” “exclusion ratio,” “market-value adjustment”—to understand all the different types of annuities. This complexity can lead to people buying annuities without fully understanding the terms. They may end up purchasing—or being sold—a product that is not the right fit for their needs.

A mortality and expense (M&E) risk charge, for instance, is often imposed on holders of annuities and other products offered by insurance companies. It compensates the insurer for any losses that it might suffer as a result of unexpected events, including the death of the annuity holder when the account balance is too low.

Your Upside May Be Limited

When you buy an annuity, you are pooling risk with all the other people buying annuities. The insurance company you buy the annuity from is managing that risk, and you’re paying a fee to limit your risk. In the same way that you may never come out ahead from buying homeowners insurance if your house doesn’t burn down, you may not make more money from an annuity than you put into it, or as much as you could have made if you had put your money somewhere else. 

The specific way in which you may not come out ahead depends on the characteristics of the annuity you buy. Here are two examples.

1. Single premium immediate annuities (SPIAs) can turn out to have been a bad choice if you experience a sudden decline in life expectancy. Your annuity can become less valuable (because it probably won’t pay out for as many years as you expected when you bought it) at the same time that you might wish you had your premium dollars back to pay for medical expenses. And unless you have paid extra for a beneficiary protection rider, or your annuity has a built-in (or optional) premium protection or return of premium feature (that you have purchased), this type of annuity leaves nothing for your heirs.
2. Indexed annuities have performance caps that limit your returns when the market does well. This drawback is the flip side of their performance floors, which are the minimum returns you will earn when the market doesn’t do so well. Indexed annuities also have participation rates that cap how much of an investment gain you get to keep. If the market returns 20% one year, you may only see 10% of that gain. If the market loses 15%, however, you still get a guaranteed minimum return or at least protection from losses.

Not all annuities provide lifetime income. For example, a fixed-period annuity, also called a “period-certain” annuity, guarantees payments to the annuitant for a set length of time, such as 10, 15, or 20 years.

You Could Pay More in Taxes

Several potential annuity disadvantages relate to taxes. 

Ordinary income vs. capital gains

A common criticism of annuity income is that it’s taxed as ordinary income, which is taxed at marginal rates of 10% to 37%. However, this aspect of annuities is less of a disadvantage than it may seem.

Traditional 401(k) distributions and traditional IRA distributions are also taxed as ordinary income. Roth 401(k) and Roth IRA distributions are not taxed because you invest in them with money on which you’ve already paid income tax. The critical comparison applies to investments held in nonretirement accounts for more than a year. These are taxed at long-term capital gains rates when they are sold.

The Internal Revenue Service (IRS) classifies capital gains as “short term” (if the investment was held for one year or less) or “long term” (if the investment was held for longer than a year). Short-term capital gains are taxed as ordinary income. Long-term capital gains are taxed at 15% for middle-income households and 20% for those earning over $445,850 (single filer) or more than $501,600 (married, filing jointly).

No step-up in cost basis

When you leave investments such as stocks, bonds, mutual funds, and real estate to heirs, they receive a step-up in basis. This means that although you may have purchased the investment for $10,000, if it is worth $20,000 when you die, the IRS considers your heirs to have acquired the investment at a price of $20,000. If they sell it immediately for $20,000, they won’t owe any taxes. If they sell it two years later for $25,000, they will only pay tax on $5,000, and that money will be taxed at their long-term capital gains rate.

If, instead, you leave your heirs an annuity that you bought for $10,000 that is now worth $20,000, your heirs would owe tax on $10,000 of ordinary income. Annuities do not have a step-up in cost basis to reduce taxes for your heirs after you die.

Tax penalties before age 59½

It’s hardly possible to read an article about annuities without reading about the disadvantage of the 10% early withdrawal penalty, but most articles don’t provide enough information about when the penalty applies. Insufficient information may have led you to think that taking any money out of an annuity contract before age 59½ will require you to pay a 10% penalty tax. It’s not that simple, and the penalty applies less often than you might think. Here’s the rule, straight from IRS Publication 575:

“Most distributions (both periodic and nonperiodic) from qualified retirement plans and nonqualified annuity contracts made to you before you reach age 59½ are subject to an additional tax of 10%. This tax applies to the part of the distribution that you must include in gross income. It doesn’t apply to any part of a distribution that is tax free, such as amounts that represent a return of your cost or that were rolled over to another retirement plan.”

This language means that if you put $10,000 into an annuity with money on which you’ve already paid income tax (a nonqualified annuity contract) and you decide to surrender your annuity, you will get back your $10,000 (a return of your cost) minus any surrender charges you owe the insurance company that issued your annuity. You won’t have to pay the IRS $1,000 (10% of $10,000). 

If your annuity is now worth $11,000, you’re younger than 59½, and you take your $11,000 back, you will owe ordinary income tax plus a 10% penalty on $1,000 (the part of the distribution that you must include in gross income). There are also other exceptions that allow you to sidestep the 10% penalty, including total and permanent disability and qualified natural disasters.

If you paid for the annuity with money on which you had not already paid income tax (for example, you bought the annuity within your 401(k), which is a type of qualified retirement plan), then you would owe the 10% early withdrawal penalty. This disadvantage is not unique to annuities. It would also apply if you sold an index fund in your 401(k) and took the money out before age 59½.

Any growth in the value of your annuity is not taxable as long as the money remains in your account. You’ll also find this tax advantage within retirement accounts. Thus, some people argue, there’s no reason to buy an annuity within a retirement account because you’re not getting any additional tax benefit from doing so. Instead, they say, you should only buy an annuity outside of a retirement account. However, that’s not always good advice.

Any growth in the value of your annuity is not taxable as long as the money remains in your account.

Expenses Can Add Up

Layers of fees can obscure an annuity’s total cost and reduce how much it pays out. Before buying an annuity, it’s important to understand what you’ll have to pay for all the features you want. While you’ll always pay a mortality and expense fee, some fees only apply to certain types of annuities. Other fees only apply if you purchase optional features that customize your annuity.

The following are common annuity expenses you should be aware of:

• Mortality and expense fee
• Administrative fee
• Contract maintenance charge
• Subaccount fee
• State premium tax (in seven states and Puerto Rico)
• Investment transfer fee
• Contingent deferred sales charge, also called a “surrender charge”
• Principal protection
• Inflation protection/cost-of-living adjustment
• Long-term care rider
• Lifetime income rider

Make sure you review the fee disclosures for any annuity you’re considering. Compare fees for similar annuities to see how their charges differ.

Guarantees Have a Caveat

An annuity’s guarantees are only as good as the financial strength of the insurer issuing it. Annuities are not insured by the Federal Deposit Insurance Corporation (FDIC) like bank accounts are. You should check the insurance company’s financial strength ratings with both AM Best and Standard & Poor’s before you buy.

If the insurance company that issued your annuity fails, a couple of outcomes are possible. Another insurance company might take over and provide a seamless transition. If another insurance company doesn’t take over, you might have to rely on the coverage provided by your state guaranty association. You can find your state’s limits through the National Organization of Life & Health Guaranty Association’s website. In many states the limit is $250,000.

Important

A return of premium (ROP) feature ensures that you will never receive less than what you put into a fixed annuity product if you surrender the annuity. You still have to follow any surrender schedule in your contract, but you will be able to exit the contract when allowed without a net loss.

Inflation Can Erode Your Annuity’s Value

Inflation erodes the value of any investment. If you’re earning an 8% return in the stock market and inflation is 2%, your real return is only 6%. If you’re earning 1% from a certificate of deposit (CD) and inflation is 2%, your real return is -1%. Likewise, if your annuity payout is not adjusted for inflation, it is unlikely to keep pace with your expenses, given long-term historical average inflation rates of just over 3%.

The good news is that you can protect your annuity from inflation by purchasing an annuity that builds in this benefit or by purchasing an inflation protection or cost-of-living adjustment rider. Expect to pay extra (or receive a lower payout) in exchange for this benefit.

The Bottom Line

Marketing strategy aside, there’s a reason why Stan the Annuity Man has a column, a website, a podcast, a YouTube channel, and several books: There’s a lot to unpack when it comes to annuities. The prospectus for an annuity can be the length of a short book and filled with unfamiliar terms, so it’s no wonder people avoid reading them and don’t fully understand these contracts.

Annuities can be an excellent planning tool to reduce your risk of running out of money in retirement, but they do come with trade-offs, such as fees and reduced investment returns. As there are so many different types of annuities, annuity issuers, and annuity products, it’s difficult to generalize about the benefits and drawbacks. It would be wise to get an opinion from at least one fee-based financial professional who isn’t trying to sell you an annuity (or an alternative to an annuity) before you purchase one of these contracts.

Read the original article on Investopedia.