What Are the Pros and Cons of Annuities?

An annuity is a financial product often used for retirement planning designed to provide a steady stream of income. While annuities offer benefits like guaranteed income, tax-deferred growth, and protection against outliving savings, they also come with drawbacks like high fees, limited liquidity and potentially lower returns compared to other investments. Understanding the pros and cons of annuities is essential for making an informed decision about whether they align with your financial goals and risk tolerance.

Consider speaking with a financial advisor about your retirement planning options.

What Is an Annuity?

An annuity is a contract between you and an insurance company. You pay for the annuity through a lump sum or multiple payments, and the company grows your assets.

There are several types of annuities. A variable annuity invests your money in certain types of funds, a fixed annuity grows via a set interest rate, and an indexed annuity earns returns based on the performance of an associated index.

However, growth only occurs during the accumulation period of your annuity. This is when you make payments and receive returns based on the type of annuity you have.

Once you’re ready to begin receiving payments, your annuity contract will enter the annuitization phase. You can receive payments in a variety of ways, including monthly, semi-annually, annually or in a lump sum. How you receive your money is completely up to you.

To protect against an early death during the accumulation phase, most annuity contracts come with some form of death benefit. Should this happen, the annuity company will send your funds to a pre-chosen beneficiary. If you pass away during the annuitization phase, payouts are determined by the type of payments you choose. For example, you can set up joint survivor payments where your spouse will take over when you die.

For an extra fee, many annuity companies will offer you the chance to customize your contract with benefit riders. As an example, let’s say you want to protect against an early death during the accumulation phase. You could purchase a death benefit rider that entitles your beneficiaries to more money than they would’ve received from the standard death benefit.

Understanding the Different Types of Annuities

There are three main types of annuities: fixed, variable and indexed.

Fixed annuity. A fixed annuity guarantees a minimum rate of interest on your money, though these rates can reset annually or every few years.
Variable annuity. A variable annuity allows you to invest your money in different investment funds, including mutual funds. The size of your payments will therefore depend on how well your investments perform rather than on a fixed rate.
Indexed annuity. While an indexed annuity is technically a version of a variable annuity, it combines the benefits of both fixed and variable products. The returns you earn from an indexed annuity aren’t based on investment decisions you make; instead, your money follows the performance of a stock market index, like the S&P 500. In this case, your money isn’t invested in the index. Instead, the annuity company will attribute your account with the returns that the index produces.

As a way to limit returns, annuity companies often use participation rates or rate caps with indexed contracts. To understand participation rates, consider this example. Say the S&P 500 grows by 10% in a year, and your contract has a 60% participation rate. The annuity company will then take that 10% growth and give you 60% of it, which would equal 6%.

Rate caps work differently. Assume the S&P 500 grows by 8% over a year, and your contract has a 5% rate cap. Your contract would receive a 5% return since the rate cap limits how much it can earn.

You can also choose an immediate or a deferred annuity.

Immediate annuity. With immediate annuities, you pay the insurance company a lump sum and begin receiving payouts immediately.
Deferred annuity. With a deferred annuity, you have the option to pay a lump sum or a series of payments, but you won’t begin receiving payouts until years later. This allows your money to earn interest or appreciate in value.

What Are the Pros of Annuities?

An annuity offers a unique way to maximize your retirement savings.

In its most basic form, an annuity is a hybrid of life insurance and retirement accounts, offering enormous flexibility in how you grow your funds. As a result, annuities have become increasingly popular due to their many benefits.

Regular Payments

The biggest benefit of an annuity is its most basic feature: the regular payouts you receive from an insurance company. These payments provide supplemental retirement income, which can help if you’re afraid that you might run out of money in retirement.

Keep in mind that the value and number of your annuity payments will vary, depending on the type of annuity and the terms of your contract.

Tax-Deferred Contributions

Contributions to an annuity are tax-deferred. That means you can make pre-tax contributions, and you won’t owe taxes on that money until you start receiving payments.

During this period between your contributions and withdrawals, it’s possible that your money could grow significantly. This type of growth is similar to how your 401(k) contributions grow.

Guaranteed Rates of Return

It's helpful to understand annuity pros and cons, as well as the different types, to see which one best suits your retirement needs.

Insurers will invest any money you put into an annuity. There’s always a certain level of risk involved when you invest money, but fixed annuities guarantee that you make a certain percentage of your principal investment. That percentage can be quite low, but it still means you’ll earn more than your original investment.

Your fixed annuity contract should include certain guarantees to prevent you from losing money.

Death Benefits

Variable annuities carry risk because they have the potential for you to lose money. On the other hand, they provide an important perk: death benefits.

A death benefit is a payment that the insurance company will make to a beneficiary if you die. For a basic variable annuity, the death benefit is usually equal to the net amount that you contributed to the annuity. If you buy an annuity contract worth $100,000, then the death benefit payout will likely be $100,000. It does not matter how your annuity’s investments perform.

Alternatively, you can find variable annuities with enhanced death benefits. With an enhanced benefit, the insurance company will record the value of your annuity’s investments on each anniversary of your annuity’s start date. If you die, the insurance company will pay a death benefit equal to the highest recorded value of your annuity.

For example, let’s say you have an annuity contract worth $100,000. You aggressively invest your money, and on the anniversary of your annuity’s start date, your investments are worth $125,000. Your death benefit would then be $125,000, even if your investments decline in value for the rest of your life.

Note that you probably should not buy an annuity if you only want a death benefit. If this is the case, you can help your beneficiaries defer funeral and burial costs with final expense life insurance.

What Are the Cons of Annuities?

Nothing in the financial sphere is perfect, and annuities are no exception. For one, annuity fees can be rather overbearing. And, while the safety of an annuity is enticing, traditional investments can sometimes be more lucrative than returns from an annuity.

Price

One of the cons of annuities can be their fees.

Variable annuities have administrative fees, as well as mortality and expense risk fees, which typically cost about 0.25% to 1.75% of your account’s value. Even the best life insurance companies charge these fees to cover both the cost and risk associated with insuring your annuity.

Investment fees and expense ratios vary, depending on how you invest. However, these fees are similar to what you would pay if you invested independently in any mutual fund. In comparison, fixed and indexed annuities are fairly cheap. Many skip the annual fees while limiting other expenses.

Companies will often allow you to customize your contract with additional benefit riders. These riders come with an additional fee, usually running between 0.25% and 1.5% of your contract value annually, but they are completely optional. They are often available for variable annuities, too.

Surrender charges are common for both variable and fixed annuities and apply when you make more withdrawals than permitted. Insurance companies usually limit withdrawal fees in the early years of your contract, which is good because surrender fees are often high and can last for an extended period.

May Not Match Investment Returns

The stock market makes gains in a good year, which could mean more money for your investments. However, your investments will not grow at the same rate as the stock market. This is largely due to annuity fees.

Let’s say you invest in an indexed annuity. Your insurer will invest your money to mirror a specific index fund, but your insurer will likely cap your gains through a participation rate. If you have a participation rate of 80%, your investments will only grow by 80% of the index fund’s total growth. You could still make great gains if the index fund performs well, but you could also miss out on valuable returns.

If your goal is to invest in the stock market, consider investing in an index fund independently. This may seem daunting if you don’t have investing experience, but a robo-advisor can help, managing your investments at much lower fees than an annuity.

Another factor to consider is taxation. You will likely pay lower taxes if you invest on your own.

Contributions to a variable annuity are tax-deferred, but any withdrawals you make will be taxed at your regular income tax rate, not the long-term capital gains tax rate. Because capital gains tax rates are lower than income tax rates in many places, you can typically avoid paying more taxes if you invest your after-tax dollars instead of investing in an annuity.

Difficult Withdrawal

Liquidity is a major concern relating to immediate annuities.

Once you contribute funds to an immediate annuity, you cannot get them back, nor can you pass them on to a beneficiary. It may be possible for you to transfer your money into another annuity plan, but doing so could also leave you subject to fees.

Additionally, your benefits disappear when you die. You cannot pass that money to a beneficiary, even if there are a lot of funds left after you pass away.

Which Type of Annuity Is Best for You?

The best type of annuity for you is entirely dependent on your situation.

If you’re a ways from retirement, the higher potential returns of a variable annuity could be enticing. On the other hand, those closer to retirement may want to choose a shorter-term fixed annuity that grows safely at a set interest rate.

More specifically, because variable annuities earn returns through investments, they offer the greatest growth potential. Annuity companies typically provide hundreds of potential investments with their variable contracts. The vast majority of these are investment funds, each focusing on specific pools of securities, such as bond funds, large-cap stock funds and small-cap stock funds.

But again, the tradeoff with variable annuities is their hefty cost. These fees make them even riskier than their investments alone.

If you prefer a lower-risk investment, an indexed annuity might be more preferable. These contracts offer a handful of indexes your assets can follow without actually investing in the index. This means you can’t lose money, but watch out for participation rates and rate caps, which can limit your overall growth.

If you do not want to risk your funds and are not worried about returns, you can open a fixed annuity. Annuity companies constantly update the fixed rates they offer, as these rates are dependent on market conditions. Most fixed annuities feature a rate floor of 1%, but it has hit around 3% during some of the best rate environments of the past.

To boot, fixed annuities offer better fixed rates than certificates of deposit (CDs).

How Annuities Are Taxed

How annuities are taxed depends on whether they were funded with pre-tax or after-tax dollars.

A contract purchased inside a 401(k), 403(b) or traditional IRA is treated as a fully tax-deferred asset. Every dollar you withdraw later, principal and growth, is taxed as ordinary income because none of it has been taxed before.

A non-qualified annuity, bought with after-tax money, is different. You recover your own contributions tax-free, but the accumulated growth is taxable.

Before the contract is converted to scheduled payouts, withdrawals are taken from the growth first. That means the early withdrawals are taxed, with the non-taxable portion coming later.

After annuitization begins, each payment is divided between a taxable component and a return of principal based on the contract’s payout formula. After your principal has been fully returned, all remaining payments become taxable.

Withdrawing money before age 59½ can trigger an additional 10% early withdrawal penalty on the taxable portion unless an exception applies. Contract add-ons, such as lifetime income riders, can also influence which dollars come out first and how payments are categorized for tax purposes.

For beneficiaries, the rules diverge again. The earnings inside a non-qualified annuity remain taxable even after the owner dies, and heirs cannot use a step-up in basis to erase that gain. They may take the payout as a lump sum or over an allowable period, and the taxable portion is then reported as ordinary income.

However, beneficiaries of qualified annuities are subject to different tax rules. They face full income taxation because the entire contract consists of pre-tax dollars.

These mechanics create a distinct tax footprint that affects not only how annuities work alongside other retirement accounts but also how distributions shape annual income for both owners and beneficiaries.

Bottom Line

A couple enjoying retirement, having considered annuity pros and cons to choose the right annuity for them.

An annuity can be a strategic way to supplement your income in retirement. For some, an annuity is a good option because it can provide regular payments and tax benefits with a potential death benefit.

However, there are potential cons for you to keep in mind. The biggest of these is simply the cost of an annuity. While some safer options, like fixed and indexed annuities, have lower fees, variable annuities can cost you quite a bit due to their higher potential for returns.

Retirement Planning Tips

Retirement planning is difficult to do on your own, but a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
An annuity is best for those who worry their savings won’t last them in retirement. Even if that sounds like you, an annuity might not necessarily be the best option. Before signing any contracts, consider some of these retirement planning moves for late starters.