You or someone you know likely owns an annuity. They used to be a popular investment, but they’re losing ground. People are realizing that the disadvantages of annuities outweigh the benefits.
Before getting to the annuity disadvantages, let’s review one big benefit: annuities provide a guaranteed payout. This can be useful in structuring cash flow. However, this can be done with other financial products that are less expensive.
8 Annuity Drawbacks
Investors generally use annuities to gain either lifetime income or tax-deferred growth. Sales agents do a heck of a job summing up the benefits. However, most agents either don’t know all the negatives or ignore them completely. So let’s consider them here:
- FDIC insurance does not cover annuities.
- Withdrawals prior to age 59 1/2 are generally subject to a 10% IRS penalty.
- Annuities are one of the highest-cost investment products in the financial industry. Average annuity annual expenses are up to three times higher than some mutual funds‘ expenses. This, of course, reduces your long-term returns.
- If you cash in a variable annuity, the government taxes gains at your income tax rate, not the lower capital gains tax rate. Also, annuities don’t guarantee gains.
- You can get similar tax-deferral benefits by buying and holding Vanguard equity and/or municipal bond index funds instead. Vanguard tends to charge much lower fees.
- If inflation picks up, fixed annuity payments lose purchasing power. (Insurance agents will counter that some products allow policyholders to raise their annual payouts by 1% to 3% a year. But that means you have to start with lower payments.)
- The principal guarantee often locks in annuity holders. The thick prospectus that annuity owners agree too often requires them to hold the annuity for many years to realize that guarantee. Additional fees – surrender penalties – are standard if the holder cashes the annuity in sooner for any reason.
- The guarantees are also only as good as the issuers. Agents may brag about their insurance company’s high ratings… but it’s good to remember that they can go bankrupt. For example, AIG used to be one of the world’s largest insurers. How confident are you that big bankruptcies won’t happen again in the future? There are state industry-backed guaranty associations, but they have limits. In a major crisis, they may not cover your insurer. (To find your state’s limit, visit nolhga.com.)
Conclusion on Annuities
Annuities do offer certain advantages, but they’re loaded with drawbacks. You’re free to make up your own mind, but now you can make a more informed decision. You’ve learned disadvantages of annuities here and can learn all of the “advantages” from sales reps.
So think long and hard before you buy an annuity. Annuities are expensive: once you’re in, you’re stuck with big fees to get out. Investors have started to catch on and are gravitating towards better investment options.
You can learn more about financial products and investing by checking out our top dividend investing articles.