Beware of Annuities: Key Risks and Costs You Should Know

Annuities are marketed as a reliable way to secure retirement income, but they come with complexities that can be costly if not fully understood. While they offer tax-deferred growth and guaranteed payments, they also include high fees, restrictive terms, and penalties for early withdrawals. Many buyers realize too late that annuities may not be as flexible or profitable as they initially seemed.

Before committing to an annuity, it’s essential to understand the risks. Contract terms, payout structures, and hidden costs can significantly impact returns.

Contractual Terms

Annuity contracts are legally binding agreements that outline the obligations of both the insurer and the policyholder. These documents can be lengthy and filled with industry jargon, making it easy to overlook clauses that limit flexibility or reduce expected returns. Some annuities lock investors in for decades, restricting access to funds beyond scheduled distributions.

Interest crediting methods vary. Fixed annuities offer a guaranteed rate, but some contracts allow insurers to adjust this rate after an initial period. Variable annuities tie returns to market performance, but insurers may impose participation rates or caps that limit growth. Indexed annuities track market benchmarks like the S&P 500 but often exclude dividends, reducing overall returns compared to direct market investments.

Death benefits also vary. Some annuities provide a standard payout to beneficiaries, while others require additional riders—at an extra cost—to ensure heirs receive the full account value. Without these riders, the insurer may retain a portion of the remaining balance.

Surrender Charges and Early Exit Conditions

Exiting an annuity early can trigger surrender charges, which insurers impose to discourage withdrawals and recover costs. These fees typically start as high as 10% in the first year and decrease annually over six to ten years. For example, a 7-year surrender period might impose a 7% penalty in year one, decreasing by 1% each year until it reaches zero.

Many annuities allow penalty-free withdrawals of up to 10% of the account value annually, but anything beyond this incurs the full surrender charge. This restriction can be problematic if an annuitant needs a larger sum for medical expenses or other emergencies.

Some contracts waive surrender charges under specific conditions, such as terminal illness, nursing home admission, or disability, though eligibility requirements can be strict. A return-of-premium feature, which allows policyholders to recover their initial investment without penalty, is sometimes available but often comes with lower returns or additional fees.

Income Payout Methods

Annuities distribute payments in different ways, affecting both the amount received and contract flexibility. Life annuities provide income for as long as the annuitant is alive, eliminating the risk of outliving savings but potentially leaving little for beneficiaries. Fixed-period annuities distribute payments over a set number of years, ensuring full disbursement but carrying the risk that payments stop before the annuitant’s death.

Immediate annuities begin payments shortly after a lump sum is invested, making them suitable for retirees who need income right away. Deferred annuities allow funds to grow before distributions begin, often requiring the annuitant to reach age 59½ to avoid tax penalties.

Customization options allow policyholders to tailor payouts, but they come with trade-offs. A joint-and-survivor annuity continues payments to a spouse after the primary annuitant’s death but typically reduces the monthly amount. Cost-of-living adjustments (COLAs) help payments keep pace with inflation but result in lower initial payouts. Lump-sum withdrawals may be available in some contracts but can reduce future payments or trigger tax consequences.

Fee Structures

Annuities come with multiple layers of fees that can erode returns over time. The mortality and expense (M&E) fee, which covers administrative costs and guarantees, typically ranges from 0.50% to 1.50% annually.

Variable annuities include investment management fees, which apply to sub-accounts similar to mutual funds. These expense ratios often range from 0.50% to 2.00% per year and are in addition to the M&E fee, meaning total charges can exceed 3% annually.

Riders, which add optional benefits to an annuity contract, introduce additional costs. Common riders include guaranteed lifetime withdrawal benefits (GLWBs) and enhanced death benefits, typically costing between 0.75% and 1.50% annually. While these features provide added security, they reduce the amount available for investment growth.

Tax Implications

Annuities offer tax-deferred growth, meaning earnings are not taxed until withdrawn. However, the tax treatment of distributions depends on the annuity type and funding source. Annuities purchased with pre-tax dollars, such as those within an IRA or 401(k), result in all withdrawals being taxed as ordinary income. Annuities funded with after-tax dollars follow the exclusion ratio, where a portion of each withdrawal is considered a return of principal and tax-free, while the remainder is taxed as earnings.

Withdrawals before age 59½ typically incur a 10% IRS penalty in addition to regular income tax. Annuity payments do not benefit from lower capital gains tax rates, meaning long-term investors may pay higher taxes on gains compared to stocks or mutual funds.

Upon death, annuities do not receive a step-up in cost basis like stocks or real estate, meaning beneficiaries may owe taxes on the full amount of deferred gains. Some contracts offer tax-efficient payout structures, such as a stretch annuity, which allows heirs to take distributions over time to minimize the tax burden, though these options often come with additional restrictions.