The Disadvantages of Annuity Contracts

When considering if buying an annuity is a good decision, it is important to understand both the advantages and disadvantages. Most commonly, the advantages are what many people who are considering annuities are shown. Having a better understanding of their disadvantages is equally important before a decision is made. The disadvantages of annuities depend on the type of annuity. These products can provide benefits for people in the right situations. However, they all have some disadvantages.

Types of Annuities and Their Disadvantages

A commonly used annuity for income is the single premium immediate annuity (SPIA). An SPIA will provide a guaranteed income for the life of the annuitant, where payments typically start one month after purchase. The guarantee is provided by the issuer of the annuity. (For more, see: Annuities and Baby Boomers: The Pros and Cons.)

There are some general disadvantages to consider. First, the benefits (income stream) are fixed and do not increase with inflation. Principal is no longer available for emergencies. This means that the buyers give up control of their money in return for an income stream guaranteed by the company who issued the annuity. This makes the financial soundness of the issuing company also important to research and understand. Many added features of these annuities often reduce income. Lastly, income per thousand dollars of principal will vary between companies who sell these products. This makes shopping for annuities very important, as different issuers will provide different income rates per thousand.

Deferred annuities come in two forms: fixed and variable. These contracts are based on the accumulation value of the investments made inside of the contract, rather than immediate payments. Taxation on the growth of the investments is deferred until withdrawals are made. There are single premium (SPDA) and flexible premium (FPDA) deferred annuities.

Fixed deferred annuities have a fixed return. These contracts, because of the fixed returns, may not keep up with competition or as the purchaser’s situation evolves, may not provide the required rate of return necessary to meet goals. If the owner wants to move the investment in this contract, they may be subject to surrender charges. Surrender charges are fees paid for exiting these contracts. Surrender charges may have a schedule that lasts many years and can be very expensive. It is not uncommon to see a 10-year surrender charge starting at 10% and going down to 0% by the 11th year. It is extremely important to understand these types of charges before buying a deferred annuity. Also, early withdrawals generally come with a 10% IRS penalty if withdrawn before age 59½.

Variable deferred annuities have variable returns and additional risks. The values of the sub-accounts in these annuities can fluctuate like mutual funds, index funds and exchange-traded funds (ETFs). These contracts include insurance company expenses. Hence, it is important to understand them and understand all the features of the annuity. If the features of these annuities are no longer desired or needed, then the purchasers may have been better off investing in funds without the insurance contract expenses that are involved with these types of annuities. The same 10% tax penalties on early withdrawals before age 59½ apply. These contracts also come with surrender charge schedules. Lastly, variability of income stream, due to the underlying performance of the sub-accounts making income unpredictable, may be undesirable.

Understanding the Pros and Cons

Ultimately, the buyer of an annuity must fully understand the features of the contract they are buying. All annuities have advantages and disadvantages that must be understood. These products can be helpful in the right situations. Finally, the individual selling the annuity should be upfront with the disadvantages and convey them. (For more, see: How to Buy Annuities When Interest Rates Are Low.)