Understanding Annuities: The Hidden Risks and Alternatives

When it comes to planning for retirement, financial products such as annuities often surface in the conversation. Promising a steady income stream, annuities seem to be an attractive option. However, they may not always be as beneficial as they sound.

Let’s delve into why you may want to approach annuities with caution and look at other income-producing alternatives.

Annuities—Buyer, Beware

In their simplest form, annuities are financial products sold by insurance companies. In exchange for your lump sum or series of payments, the insurance company agrees to make regular payments to you for life or a specified period. While the assurance of a guaranteed income may seem appealing, several factors may significantly diminish the value of this purchase.

First, although some annuities don’t charge fees, other ones—particularly variable annuities—are notorious for their high fees. Annual fees can range from 2% to 3%, with some annuities charging more.

These charges can include management fees, mortality and expense risk charges, administrative fees, and surrender charges. Commissions also get built into the costs you’ll pay.

Second, the guaranteed income stream depends on the insurance company’s financial stability. If the company were to go bankrupt, it could put your income at risk. Even though there are state guaranty associations to protect consumers, they only cover up to certain limits and may not fully cover your investment.

In addition, annuities can be complex and often lack transparency. The contract’s fine print can be filled with terms and conditions that make understanding the returns and penalties challenging.

Before you sign the dotted line, you may want to talk to an objective third party, such as a fiduciary financial advisor, about whether the policy can meet your expectations.

Finally, annuities might not suit everyone due to their illiquid nature. If you unexpectedly need a large sum of money, getting it out of some annuities can be expensive because of early withdrawal penalties.

Annuity Alternatives to Consider

With annuities’ inherent complexities and potential risks, you may want to consider alternatives, such as a diversified, long-term investment portfolio.

Such a portfolio is a collection of different kinds of investments balancing potential risks and rewards. This strategy can include asset classes such as stocks, bonds, real estate, and commodities. A diversified portfolio isn’t tied to the financial health of a single company, sector, or geographic location, helping to reduce risks and potentially provide higher returns.

With a long-term investment approach, you have the opportunity to ride out market volatility. Historically, markets have risen over the long run despite short-term fluctuations. This past performance is no guarantee of future results; however, staying invested and periodically rebalancing your portfolio to align with your goals and risk tolerance could generate meaningful investment wealth over time.

In addition, you might consider the following for income:

1. Real estate: Investing in real estate can provide a steady stream of rental income and potential asset value appreciation. Ownership, however, involves ongoing management and upkeep. You also face market risks associated with location and general economic conditions.

2. Tax-advantaged retirement accounts: Contributing to certain retirement accounts can offer tax advantages. For example, with traditional IRAs and 401(k)s, your contributions are tax-deductible, and your investments grow tax-deferred until retirement. Roth IRAs and 401(k)s are funded with after-tax dollars, but withdrawals in retirement are tax-free. Strategically using a mix of such accounts can help increase your tax flexibility in retirement.

3. Savings accounts and CDs: While these don’t offer high returns, they are generally low-risk and can be suitable for those close to retirement or for a portion of your savings that you want to keep protected from market fluctuations.

4. Bonds: Bonds can provide regular interest income and are generally considered lower risk than stocks. However, they can still lose value, such as when interest rates rise.

5. Dividend investing: This strategy involves buying stocks that regularly pay dividends. The dividends can serve as a regular income stream while offering the potential for capital growth.

6. Social Security: While not an investment, Social Security benefits can provide a significant and guaranteed income source during retirement. However, it’s not advisable to rely solely on Social Security as it is not designed to cover all your needs in retirement.

As always, it’s important to consider your financial situation, risk tolerance, and retirement goals when choosing your income strategy. Consulting with a financial advisor can be beneficial in creating a personalized financial plan.

We generally recommend a fee-only, fiduciary financial advisor to help ensure that you receive unbiased advice. These advisors don’t earn commissions, reducing potential conflicts of interest. The fiduciary advisor’s primary goal is to serve your best interests.

Schedule a complimentary, 15-minute chat with a fee-only, fiduciary financial advisor today to discuss your personal situation.

This material was written in collaboration with artificial intelligence (ChatGPT) derived from sources believed to be accurate. This information should not be construed as investment, tax, or legal advice.

Parkshore Wealth Management is a family-owned, independent, fee-only Registered Investment Advisor with offices in Roseville and Folsom, CA, and Lehi and Logan, UT. We partner with financially responsible individuals and families who are eager to take positive steps that will allow them to use their money to build the life they desire. The firm is led by Harold Anderson, CFP®, and Daniel Andersen, CFP®, both members of NAPFA, the country’s leading professional association of fee-only financial advisors.