What Consumers Need to Know About Annuities

Common retirement savings options like 401(k) and IRA plans are good ways to supplement Social Security benefits and create a sound cushion post-employment. Some people add whole life insurance, which combines life insurance with an investment component.

Another possible option is an annuity, typically sold by an insurance company as a way to guarantee income in retirement for the rest of a policyholder’s life. In an annuity, the policyholder contributes a lump sum, which is then invested. At an agreed-upon time, the policy is “annuitized,” meaning it begins paying out a specified amount every year. Annuities can come in a wide variety of models, with varying time frames, payment amounts and lengths.

We asked Steven Elwell, a financial advisor and a member of NerdWallet’s Ask an Advisor network, about what consumers should keep in mind if considering annuities.

In what situations might annuities be a viable investment product?

Annuities can be appropriate for conservative investors who anticipate eventually annuitizing the account to create a guaranteed source of income for the rest of their lives. This may make sense for a person who is very concerned they will run out of money if they live to old age.

An annuity may also be appropriate for very-high-income savers who need tax deferral and have already maxed out their 401(k) plans and IRA options.

Those who do decide to use annuities as an investment product should be very conscious of the cost, as there are several layers of fees that will apply that could drastically reduce the returns over the long term.

What are the main advantages and disadvantages?

The main advantages of annuities are:

• Tax deferral.
• The ability to purchase riders that may guarantee a minimum amount of growth or withdrawals in retirement.
• The ability to transfer longevity risk to an insurance company, which will guarantee income payments for the rest of your life.

There are several main disadvantages:

• High costs in the form of investment fees and other charges by the insurance company.
• Limited investment options.
• Layers of complexity that often make it hard for consumers to understand how the product works.
• Potential “surrender” charges if you terminate your policy.
• Potential penalties for withdrawals before age 59½.
• The taxing of gains as “ordinary income” instead of potentially lower long-term capital gains rates on non-retirement accounts.
• No access to the account value once an annuity is annuitized — the customer simply receives payments.

Are annuities preferable to whole life insurance policies?

Annuities may be preferable to whole life insurance policies from an investment perspective because of the ability to guarantee payments or minimum growth/withdrawals. For most people, though, IRAs and 401(k) plans will be the first option when saving for retirement. Non-retirement brokerage accounts will also be more attractive than annuities or life insurance for many investors because many people qualify for the 0% long-term capital gains rate.

Anything else consumers should keep in mind when it comes to annuities?

Unfortunately, the majority of annuities are sold, not bought, meaning that an agent potentially recommended the product because of the higher commission and not because it was the right fit for the consumer. Many people are very upset to hear about the surrender charges they face, and very few understand the layers of fees associated with annuities.

My advice for consumers who are in the market for an annuity is to shop around and ask a lot of questions. You’d be surprised how different guaranteed payments quotes can be from company to company.

Steven Elwell is a certified financial planner and vice president of Level Financial Advisors.