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An annuity is a contract issued by an insurance company that pays a stream of income for a specified period or often for the remaining life of the contract holder.

Annuities are often sold by insurance agents and registered representatives as a way to provide income for their client’s retirement needs. But annuities have several pros and cons to consider before investing your retirement funds there.

How an annuity works

When you purchase an annuity, you hand over a lump sum of money or a series of premium payments to an insurance company. In exchange, the insurer promises to pay you a series of payments now or in the future. Those payments can last for a specific number of years or for the rest of your life — no matter how long you live. Money invested in an annuity grows tax-deferred, meaning you’re taxed upon withdrawal or when payments begin.

Annuity contracts are highly customizable. Critics might argue this is what makes annuities so confusing. There are numerous riders available, each offering different features and each driving up the overall cost and complexity of an annuity contract.

The main types of annuities are:

  • Variable annuities. Premium payments into a variable annuity are invested in one or more sub-accounts which are similar to mutual funds. The value of the annuity is determined by the performance of investments in those accounts.
  • Fixed annuities. A fixed annuity guarantees a minimum rate of return. The rate can be reset periodically over time or increase  annually.
  • Indexed annuities. An indexed annuity tracks an index like the S&P 500 and offers a capped return based on the total returns of the index. Indexed annuities generally offer a minimum level of return as well.

Some annuities are immediate, meaning that annuity payments can begin within a year or less after the premium is paid. Others are deferred annuities, meaning that payments begin at some point in the future, as stipulated in the annuity contract.

Pros and cons of annuities

Annuities can be a tool in your retirement planning strategy, offering reliable income and tax advantages. However, like any financial product, they have their pros and cons. Understanding these can help you make an informed decision about whether an annuity is right for you.

Advantages of annuities

1. Regular payments

In an era when employer pensions have gone all but extinct in the private sector, annuities can offer contract holders the opportunity to receive guaranteed  monthly payments. These payments can provide regular, dependable income through retirement, or provide a bridge to Social Security if you chose to retire early. Here’s how an annuity compares to an IRA.

2. Lifetime income

Annuities can be structured to provide regular payments for the rest of your life — no matter how long you live. Not outliving your savings is a huge advantage touted by annuity providers. While anyone’s actual life expectancy is almost impossible to predict, the fear of running out of money in old age is a real concern for many Americans.Just keep in mind to secure a lifetime of guaranteed income, you’ll likely need to purchase a rider.

3. Tax-deferred growth

Money inside an annuity grows tax-deferred. Gains on the amount of premium invested in the contract grow with no taxes due until the money is withdrawn, assuming the annuity is non-qualified, meaning that it’s not held inside an IRA or other retirement account.

If money is withdrawn in lump sums, it’s considered a withdrawal of capital gains first, making it fully taxable. In contrast, only a part of regular annuitized payments are subject to tax, because a portion of the payment is considered a return of the cost basis (and so not taxable) while the rest are taxed as capital gains.

4. Guaranteed rates of return

Some annuity contracts, typically fixed annuities and indexed annuities, offer guaranteed rates of return. While your rate of return on these annuities can be higher than the minimum, it’s nice to know there is a floor on the rate of return, too. However, sometimes this floor can be a loss instead of a gain.

5. Survivor benefits

Annuity contracts offer several options for survivors of the contract holder, though they vary from insurer to insurer. The contracts will typically offer an option to designate beneficiaries in the event of the account holder’s death.

In addition, annuities may offer options that allow survivors to continue to receive payments upon the annuitant’s death. This might be a joint and survivor option for a spouse or a “period certain” option for a non-spousal beneficiary.

Disadvantages of annuities

1. High expenses and commissions

Cost is one of the biggest drawbacks of annuities.  Expenses erode the owner’s returns, especially on a variable annuity where the value depends on the investment returns. Some annuity contracts are so complex that the full rate of the internal expenses is hard for the average person to  understand.

Annuities are typically sold by insurance agents, not financial advisors. That means they earn a commission on the products they sell you. While the commission is usually baked into the annuity contract, it can amount to anywhere from 1-10 percent of the total value of your contract.

2. Difficult to exit

While it may be possible to get out of an annuity contract, it comes at a cost. Some insurers make it difficult to exit an annuity by imposing high surrender charges. These charges might amount to 10 percent or more of the value of the contract. Typically, the surrender charge will decline over time.

And you’re not able to get out of the contract whenever you want, since annuities typically have a limited surrender period. These periods usually last six to eight years after purchasing the annuity, but it depends on the contract.

3. Possibility of an insurer defaulting

Annuities are guaranteed by the insurance company that issues the contract. While there have not been a lot of defaults on annuities, it can still happen. The backup to the insurance company is your state’s guaranty association. It is a good practice to check on the financial solvency of an insurer before purchasing an annuity contract.

4. Highly complex

The contractual language in an annuity is complex, making it difficult for the average person to understand what their rights and responsibilities are and what they’re getting for their money. Annuities can differ markedly from one another, making it difficult to compare them.

Worse, because sales people earn a commission by selling annuities, they are not incentivized to highlight all the fine print or risks to potential buyers.

Frequently asked questions (FAQ)

  • Annuities can lose value, especially variable annuities, where returns are tied to investment performance, so poor-performing investments can lead to a lower account value. Indexed annuities may return less than expected due to costs like caps and fees. Early withdrawals can also incur surrender charges, reducing the value of the contract. Additionally, if the issuing insurance company fails, there could be a risk of loss, although there’s some regulatory protection. Remember that high fees and expenses can also diminish annuity value over time.
  • Annuities offer benefits like a steady income in retirement and tax-deferred growth with no annual contribution limits. However, they can come with high annual fees, early withdrawal penalties and may not provide inheritance for heirs. The suitability of an annuity as an investment depends on individual financial goals, risk tolerance and retirement plans. It’s always smart to consult a financial advisor before making a major financial decision like buying an annuity.
  • Yes. The tax treatment varies depending on whether you bought the annuity with pre-tax (qualified) or post-tax (non-qualified) funds. For qualified annuities, withdrawals are fully taxed as income. For non-qualified ones, only the earnings are taxed.

Bottom line

Annuities come in many varieties and offer owners a way to provide a guaranteed stream of income for a specified period or for life. They are another way to invest on a tax-deferred basis for those who have maxed out other retirement plan options. Despite some advantages, many annuities carry obscenely high expenses and surrender charges, in addition to being tremendously complex.

Bankrate’s Rachel Christian contributed to an update of this story