Personal Finance

The Hidden Downsides of Annuities That Can Demolish Your Retirement

David Beren

Published: January 20, 2025 2:16 pm

When you consider the different methods you can utilize to earn money for retirement, an annuity is often a discussion worth having. For many people, the idea of guaranteed income is a comfort they are more than willing to enjoy in retirement. 

However, some hidden downsides of annuities cannot be ignored. Annuities are complex, and because of this, there is a lot of confusion among those who might be considering them, so it’s a good idea to look at the hidden downsides before you get started. 

Beware of High Fees

Among the most significant potential downsides of any annuity product is that you must navigate the idea of high fees. Yes, you have guaranteed income, but you’ll also pay a little more than you originally intended. 

Management Fees

Management fees are particularly important if you are considering or have already invested in variable annuities. This annuity type is generally invested in a mutual fund, and the value of your account rises (or falls) based on the investment. 

Things get interesting as a management fee can be applied periodically whenever the annuity is invested, and the insurance company monitors the fund portfolio. This fee typically ranges between 0.25% and 1%, and it’s built into your fund, so you won’t even see it on any statement you get, just on the fine print when you first signed up for the annuity. 

Surrender Charges

A surrender charge is among the more surprising fees or charges you’ll find with an annuity. While this isn’t universally true across all annuities, this charge has a bit of bite and is very much a hidden downside. 

The bottom line is that a surrender charge can be expensive, up to 7% in some cases, depending on the type of annuity. This charge is because when you purchase an annuity,  you’ll have to pay the salesperson a commission check upfront, which is where this large percentage comes into place. 

To be clear, this fee also revolves around the idea that the insurance company is looking to use your money to recoup the cost it paid. The reason is that if you want to pull any cash out early, for whatever reason, you are going to be charged a penalty known as a surrender charge. The good news is that this fee will decline over time, so what you pay in year 2 will be different than what you might pay in year 10. 

For example, if you wanted to invest $100,000 into an annuity but needed to pull out $10,000 in the first year, you’d likely be paying upwards of $1,000 in a surrender charge. This surrender charge would go down if you wanted to pull the same amount out in year 8. 

Rider Charges

When you think about a rider, it could be something you add to an annuity for any reason. It could be related to cost-of-living, long-term care, death benefit, or anything related. In these cases, you would need to pay extra money, generally around 1% or more annually, to have a rider attached. Of course, this also comes with the downside of compounding the annual fees you are already paying, so you may now spend upwards of 2-3% annually for one annuity as soon you attach a rider. 

Insurance Charges

Anytime you pick up an annuity and think about guaranteed income, you also have the downside of incurring insurance charges. These fees will be included annually to cover any expenses from the insurance company providing and promoting the annuity, plus the cost of any guarantees that might be attached to the annuity. In this case, you’re likely looking at around 1% annually, meaning all these potential fees quickly add up to around 3% of your total annual annuity. 

When you combine all these fees on paper, you see how your return erodes as you spend money to make money. At 3% per year, this would be especially difficult with a fixed annuity where you don’t have the potential to make money over time that could offset these fees. The bottom line is that any costs you incur will eat away at any compounding growth you have, which makes an annuity less attractive. 

Liquidity Restrictions 

Another hidden downside of annuities is that liquidity restrictions will limit your flexibility with the money. 

Limited Access to Funds

First and foremost, the most significant liquidity restriction is that you have minimal access to your funds over time. In an emergency, you can take money from an annuity, but most annuities only allow up to 10% of the total balance to be withdrawn without a penalty, which may not meet your emergency fund needs. If you want to withdraw more than 10%, you’re likely looking at surrender charges, which decline with time but still require you to pay a not-so-insignificant amount back to the insurance company. 

Inflation Concerns

One of the biggest downsides of a fixed annuity is that while you have the benefit of knowing your exact payout, there is no adjustment for inflation. This means your purchasing power is eroded over time, so what you buy today won’t have the same value in 10-20 years. For example, if you look for a $100,000 fixed annuity payout, you’d see a $600 monthly payout at age 60. However, if you have 20 years before the payout begins, the buying power of $600 will drop dramatically between now and when you start taking payouts. 

Not For Short-Term Needs

When you purchase an annuity, you are looking at something you invest in for the long term. This makes annuities unsuitable for any individual or couple wanting access to large amounts of liquidity in an emergency. This might include emergency costs around health care or buying a new home when liquidity is essential. Roth IRAs or index funds are the better options for these individuals, as they come with fewer restrictions that could benefit large liquidity. 

Better Alternatives for Retirement Savings

Knowing the potential downsides of an annuity, you will likely want to pivot your retirement savings plans into lower-risk alternatives. 

Low-Cost Investments 

Anyone wanting plenty of market diversification should consider investing money into ETFs or index funds. Yes, you may still pay a small fee to a financial advisor, but you’ll spend less than an annuity over 20 years and the cost difference can result in tens of thousands of savings. 

CDs 

While the value of a CD fluctuates based on interest rates, this might be a strong idea for short-term investments for those who want to remain risk-averse with no fees. This makes CDs a safe alternative and gives you an exact idea of how much you will earn, similar to some annuity types, and the interest rates may even exceed fixed annuity payouts. 

Roth/Traditional IRAs

As mentioned earlier, investing in either a Roth or Traditional IRA, which have different tax impacts, will provide you with greater flexibility without having any fees similar to those of an annuity. You can also withdraw contributions from a Roth IRA penalty-free anytime, eliminating potential liquidity concerns.