Disadvantages of an annuity

While annuities serve a purpose in certain financial situations, they carry substantial drawbacks that deserve careful consideration.

As  Scott Neubauer, financial advisor at Wisdom Investments, points out, “People ‌push ‌annuities ‌like they’re some foolproof, easy retirement answer, but that sales talk dodges the actual downsides. Lots of them trap your cash with penalties for pulling out early, lasting years; turns into a real pain when your health takes a turn or family stuff flips or taxes shift around. On the returns side, steep built-in costs, limits on how much you gain, plus those twisted ways they calculate credits, all that usually leads to pretty lackluster growth over the long haul compared to just a basic spread-out set of holdings.”

The following disadvantages can significantly impact your wealth, flexibility, and financial legacy.

• Limited liquidity and access to your money: One of the most significant downsides of annuities is the severe restriction on accessing your funds. Unlike a savings account, brokerage account, or even most retirement accounts, annuities are designed to lock up your money for extended periods. This illiquidity can create serious problems if your circumstances change or emergencies arise. This sentiment is supported by Pedro Silva, a financial advisor at Apex Investment Group, LLC: “A client can generate high income but will damage that income stream if he or she accesses the principal. Monthly income is great, but there are expenses, emergencies or opportunities that often come up that need access to lump-sums beyond the monthly guarantees.”

• Surrender charges and withdrawal penalties: Most annuities impose surrender charges if you withdraw money during the surrender period, which typically lasts six to eight years but can extend beyond a decade in some contracts. According to the Financial Industry Regulatory Authority (FINRA), surrender periods and associated charges vary widely among annuity products, making it critical to understand these terms before purchasing. Some contracts allow penalty-free withdrawals of 10% annually, but this still leaves the majority of your funds inaccessible without significant cost.

• Emergency access limitations: Life is unpredictable. Medical emergencies, home repairs, family crises, or unexpected opportunities can require immediate access to substantial funds. When your money is locked in an annuity with steep surrender charges, you face an impossible choice: pay exorbitant penalties to access your own money or forgo addressing the urgent need. This illiquidity can force you into high-interest debt or prevent you from capitalizing on time-sensitive opportunities.

• High fees can eat into your returns: Annuities are notorious for their fee structures, which are often among the highest in the financial services industry. These fees can dramatically reduce your returns over time, potentially negating much of the benefit the annuity was supposed to provide.

• Mortality and expense risk charges: Variable annuities typically charge mortality and expense (M&E) risk fees to compensate the insurance company for the risk they’re assuming by guaranteeing certain benefits. These fees usually range from 1.0% to 1.5% of your account value annually. This might not sound like much, but over decades, it compounds into substantial money.

• Administrative fees and rider costs: Beyond M&E charges, annuities often include administrative fees for record-keeping and other services, typically ranging from 0.10% to 0.30% annually. The Securities and Exchange Commission (SEC) warns investors that variable annuity fees and expenses can significantly reduce returns over time. When you stack M&E fees, administrative costs, underlying investment fees, and rider charges together, you might easily pay 3% or more of your account value annually.

• Complexity makes annuities hard to understand: Annuities rank among the most complicated financial products available to consumers. Their contracts are dense, filled with industry jargon, and structured in ways that make it difficult to understand exactly what you’re buying.

• Confusing contract terms and fine print: Annuity contracts can run to hundreds of pages and include participation rates, cap rates, spread fees, guaranteed minimum withdrawal benefits, and numerous other features that interact in non-intuitive ways. For indexed annuities, understanding how your returns are calculated often requires advanced mathematical knowledge.

• Difficulty comparing products across providers: Because each insurance company structures its annuities differently, with unique combinations of fees, caps, floors, and guarantee provisions, comparing products across providers becomes extraordinarily difficult. Unlike mutual funds, which have standardized disclosure through prospectuses and are easy to compare based on expense ratios and performance, annuities resist straightforward comparison. This lack of transparency benefits insurance companies and commissioned salespeople while disadvantaging consumers. You might think you’re getting a competitive product, but without the ability to easily compare apples to apples, you’re essentially making an educated guess at best.

• Lower returns compared to other investments: Despite their marketing, annuities typically deliver inferior returns compared to simpler, lower-cost investment alternatives.

• Conservative investment allocations: Fixed annuities generally offer returns that barely keep pace with inflation, often ranging from 2% to 4% in recent years. While they provide safety and guarantees, this conservative return profile means your money grows slowly, potentially leaving you short of your retirement goals. Variable annuities give you market exposure, but the high fees dramatically reduce your net returns. According to research from Morningstar, the average variable annuity charges approximately 2.3% in total annual fees. When the stock market averages 10% annual returns historically, that 2.3% fee effectively reduces your returns by nearly a quarter.

How fees reduce overall performance

The impact of fees compounds devastatingly over time. Consider two investors who each start with $200,000 at age 55:

• One invests in a variable annuity with 2.5% annual fees, while the other invests in a low-cost index fund portfolio with 0.2% fees.

• Assuming both earn 8% gross returns annually, by age 75, the index fund investor would have approximately $750,000, while the annuity investor would have only about $570,000—a difference of $180,000 despite identical market performance.

• This fee drag is particularly problematic because it’s invisible in the moment. You don’t write a check for $5,000 each year; instead, the money simply disappears from your account value, making the true cost easy to ignore until it’s too late.

Additional factors that can lessen the value of your annuity include:

• Inflation risk can erode your purchasing power: Inflation is one of the greatest threats to retirement security, yet many annuities fail to adequately address this risk. According to John A. Wright, Chief Investment Officer at Stellar Assets, “Inflation has averaged 3% over the last 4 years. Few believe it is going lower as politicians have anchored on the idea of spending money they don’t have. Your plan assumes 2%, making 5% almost sound profitable, but bump inflation by just a couple of points and that annuity is down to a zero percent return after taxes.”

• Fixed payments lose value over time: If you purchase a fixed immediate annuity that pays $2,000 per month, that amount might seem adequate today. However, with even modest 3% annual inflation, the purchasing power of that $2,000 payment will decline to approximately $1,340 in today’s dollars after 15 years. What buys groceries and pays bills today will cover substantially less in the future. According to data from the Bureau of Labor Statistics, even during periods of relatively low inflation, the cumulative erosion of purchasing power over retirement can be substantial. This makes fixed payments particularly risky for younger retirees who may live 30 or more years in retirement.

• Tax treatment disadvantages: While annuities are often marketed as tax-advantaged products, their actual tax treatment creates several significant disadvantages compared to other investment vehicles.

• No step-up in basis for heirs: When you invest in stocks, mutual funds, or real estate outside of an annuity and then pass away, your heirs receive a step-up in cost basis to the value at your death. This means if you bought stock for $50,000 that grew to $200,000, your heirs can inherit it and immediately sell it without owing any capital gains taxes on that $150,000 appreciation. Annuities receive no such benefit. Your heirs will owe ordinary income taxes on all the gains in the annuity, potentially at rates as high as 37% at the federal level, plus state taxes. This can result in nearly half of your annuity gains going to taxes instead of to your beneficiaries.

• Ordinary income tax on gains: Even during your lifetime, withdrawals from non-qualified annuities (those not held in IRAs) are taxed as ordinary income rather than at the lower capital gains rates. If you had invested the same money in a regular brokerage account, any gains would be taxed at long-term capital gains rates of 0%, 15%, or 20%, depending on your income. The difference between a 20% capital gains rate and a 35% ordinary income rate can cost you tens of thousands of dollars over retirement. The Internal Revenue Service (IRS) treats annuity distributions as ordinary income, which can also push you into higher tax brackets and potentially trigger additional Medicare premiums or affect the taxation of your Social Security benefits.

• Loss of control over your investment: When you purchase an annuity, you’re ceding control of your money to an insurance company, which creates several concerning implications.

• Limited investment options: Variable annuities restrict you to a limited menu of sub-accounts chosen by the insurance company. These investment options are typically more expensive than comparable mutual funds or ETFs you could purchase directly, and you have no ability to branch out into alternative investments, individual stocks, or other strategies you might prefer. This limitation becomes particularly frustrating when you identify attractive investment opportunities or want to adjust your strategy in response to market conditions. You’re locked into the insurance company’s offerings, regardless of their performance or cost-effectiveness.

• Impact on your estate and beneficiaries: The disadvantages of annuities extend beyond your lifetime to affect your heirs and the legacy you leave behind. Beyond the tax disadvantages already discussed, annuities can substantially reduce what you pass to your heirs in other ways. Many annuity contracts terminate or significantly reduce payments shortly after, the insurance company keeps the remaining funds—your heirs receive nothing, even if you only received a fraction of your principal back.

Better alternatives to consider

Given these substantial disadvantages, many retirees are better served by alternative strategies that provide similar benefits without the drawbacks.

• A diversified portfolio of low-cost index funds can provide market returns with minimal fees—typically 0.03% to 0.20% annually compared to 2-3% for annuities. This fee difference translates to hundreds of thousands of dollars over a retirement lifetime. You maintain complete liquidity, control, and the ability to adjust your strategy as circumstances change.

• Bond ladders—portfolios of individual bonds with staggered maturity dates—can provide predictable income similar to an annuity but with complete transparency, lower costs, and the return of your principal. If interest rates rise, you can reinvest maturing bonds at higher rates. If you need access to funds, you can sell bonds without surrender penalties.

• For guaranteed income, delaying Social Security benefits often provides a better return than purchasing an annuity, with inflation protection built in and spousal benefits that protect your partner. According to research from the Center for Retirement Research at Boston College, delaying Social Security from age 62 to 70 increases your monthly benefit by approximately 76%, creating a powerful form of longevity insurance without the fees and restrictions of commercial annuities.

• For guaranteed lifetime income beyond Social Security and have maxed out other options, a simple single-premium immediate annuity (SPIA) purchased at age 75 or later typically offers better value than the complex deferred annuities heavily marketed to younger retirees.

Questions to ask before purchasing an annuity

If you’re still considering an annuity despite these disadvantages, ask these critical questions:

1. What are the total fees, including all riders and underlying investment costs? Get a specific dollar amount, not just percentages. How long is the surrender period, and what are the penalties for early withdrawal? What portion of your retirement assets would this annuity represent, and could you afford to have that money locked up?

2. What happens to your money if you die shortly after purchase? What does your spouse or partner receive? How do the guaranteed returns compare to current Treasury bond rates or high-quality corporate bonds? Are you being pressured to decide quickly, or do you have adequate time to review the contract and consult with a fee-only financial advisor who doesn’t sell annuities?

3. What problem are you trying to solve with this annuity, and are there simpler, less expensive ways to address that need? If the annuity salesperson is emphasizing tax deferral for a non-qualified annuity, recognize that you can achieve similar or better tax treatment through regular investment accounts with far more flexibility.

When’s the right time to sell your annuity?

If you already own an annuity and are questioning whether to keep it, several situations might warrant selling despite surrender charges:

• If you’re still within the free-look period (typically 10-30 days after purchase), you can cancel without penalty and receive a full refund. If your surrender period has expired or the remaining charges are minimal, the benefits of liquidity and control might outweigh the exit costs. If you’re facing a financial emergency and have no other options, paying the surrender charge might be your best bad option.

• Calculate the break-even point by dividing the surrender charge by the annual fee savings you’d realize by moving to a lower-cost investment. If you’d break even within two to three years and expect to live longer than that, selling might make financial sense even with a penalty.

• However, if your surrender period has expired, you might choose to keep it while ensuring no new money flows into similar products. Some older annuities have attractive features that aren’t available in new contracts, making them worth retaining despite the general disadvantages of the category.

The bottom line

Annuities can serve legitimate purposes in specific circumstances, particularly for retirees with very high risk aversion, those lacking other sources of guaranteed income, or individuals concerned about cognitive decline affecting their ability to manage investments in late retirement. However, for most people, the disadvantages—limited liquidity, high fees, complexity, lower returns, inflation vulnerability, poor tax treatment, loss of control, and negative estate implications—substantially outweigh the benefits.

Before committing to an annuity, thoroughly evaluate alternatives like optimizing Social Security claiming strategies, building diversified portfolios of low-cost index funds, creating bond ladders, or maintaining sufficient cash reserves to reduce sequence-of-returns risk in early retirement. In most cases, these approaches provide superior flexibility, lower costs, better returns, and more favorable outcomes for both you and your heirs. The guaranteed income from an annuity comes at a price that’s often much higher than advertised and rarely worth paying.

SOURCES CITED

1. Financial Industry Regulatory Authority (FINRA). “Annuities.”
2. Securities and Exchange Commission (SEC). “Variable Annuities: What You Should Know.”
3. Morningstar. “Why Are Annuities So Expensive?”
4. Bureau of Labor Statistics. “Consumer Price Index.”
5. Internal Revenue Service (IRS). “Publication 575: Pension and Annuity Income.”
6. Center for Retirement Research at Boston College. “How Much Does It Cost to Delay Social Security?”

*This information is provided for educational and informational purposes only. Such information or materials do not constitute and are not intended to provide legal, accounting, or tax advice and should not be relied on in that respect. We suggest that You consult an attorney, accountant, and/or financial advisor to answer any financial or legal questions.