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Annuities: A Good Option in Turbulent Times?

As Americans get older and the stock market goes through a periodic decline, the temptation to decrease risk over fears of running out of money makes people turn to annuities, according to a recent New York Times article, Annuities as an Alternative to Shaky Markets? Not So Fast. Single-premium immediate annuities (SPIA) are an especially enticing option as Americans near retirement, because by paying an upfront premium, people can draw a payment periodically for the rest of their lives.

While annuities may have benefits as a steady source of income, there are several reasons to be wary of them. Here are some key things to consider when mulling an annuity purchase. (For related reading, see: What You Should Know About Fixed Indexed Annuities.)

Lower Expected Returns

The long-term return on an annuity is probably not going to be as good as investing the money in stocks, bonds or funds. For example, as the article points out, the return on a broad-based stock index fund is much more likely to outperform the return on an annuity over the long term, especially with today’s extremely low interest rates.

Hidden Costs

Annuities can be very expensive and often have high fees, hidden costs and surrender charges. These surrender charges, found in most annuities, are essentially a penalty for an early cancellation or a withdrawal, so money can be locked up for a very long time.

Not Risk Free

Though deemed by some as super-safe, annuities are not without risk. The investor or his financial advisor should always check that the insurance company has a good credit rating and a sound balance sheet. If not, that could spell trouble down the road. (For related reading, see: Why Retirement Optimism Is Slipping for Many Americans.)

Hard to Get Out Of

Annuities are often very difficult to get out of due to early termination fees and potential tax issues. Thus, annuities should never make up all of an investor’s portfolio because it could have severe repercussions if unexpected expenses crop up. Each investor’s particular situation is unique, but it is best to put aside money for healthcare costs and emergency funds before even thinking about an annuity.

Conflicts of Interest

Consider the advisor who is selling the annuities, because they often do not have the investor’s best interests at heart given the high commissions they earn for selling annuity products.

Alternatives to Annuities

Alternative and potentially better ways to decrease risk than buying an annuity exist, including managing expenses correctly, reducing debt, paying off mortgages, and working longer to delay Social Security.

In summary, annuities may be likened to the low nutritional value comfort food you love to consume every day—by doing so, you're missing out on so many more delicious-tasting foods that are way healthier for you in the long run. While annuities may appear to be a safe bet when markets are on the decline, an investor may be far better off using the lump-sum or lifetime annuity money to invest elsewhere for a greater return. It's likely best to make investment decisions with a long-term perspective based on a rational approach and fundamental valuations. (For related reading, see: How Annuities Can Boost Your Retirement Confidence.)