Spoiler alert: I'm not a big fan of annuities.
Annuities often come with astronomical fees and commissions, some of which can be quite difficult for investors to identify and understand. More often than not, I find myself trying to talk retirees out of buying annuities.
Having said that, there are some cases when buying an annuity could make sense. Here's the major problem with annuities, as well as five situations where buying an annuity isn't necessarily a bad decision.
Annuities often have high fees
The primary reason not to buy an annuity is because of the fees that come with them. Annuities often pay massive commissions (as much as 10% isn't uncommon) to the brokers who sell them and have high surrender charges if you decide to take your money out.
Variable annuities also have annual investment management and insurance fees that can run in the 2%-3% range. For comparison, a 1% annual expense ratio for a mutual fund is on the high end, and you can find index funds with annual expenses as low as 0.03%.
But they could be smart choices in some cases
While annuities tend to come at a high cost, there are some cases where they can make sense. Here are five common situations:
1. You have a low risk tolerance
Annuities, particularly fixed annuities, can provide virtually guaranteed income for life, and for a price, you can even get inflation protection. For this reason, annuities can be appropriate for investors with extremely low risk tolerance. In other words, if investing in U.S. Treasury Bonds sounds too risky to you, a fixed annuity might be just what you're looking for.
2. You don't want to worry about outliving your savings
Although I never plan to buy an immediate annuity, a deferred annuity could be the only reason I would ever consider using some of my own retirement savings on an annuity. In a nutshell, running out of income in retirement can cause major problems -- especially in the later years when it may not be practical to get a part-time job.
Essentially, a deferred annuity is a form of insurance against running out of money as you get older. These work by paying for the annuity now in exchange for a series of payments to start at some point in the future. For example, you can buy a deferred annuity when you're 55 that doesn't start making payments until you're 75.
3. Predictable income is your No. 1 priority
There are many different investment priorities of retirees. Leaving money to loved ones, preserving your capital, growing the nest egg year after year, and steady, predictable income are some good examples. If the last one -- steady, predictable income -- is by far your biggest priority, an annuity could make sense.
4. You want a zero-maintenance investment strategy
One of the biggest advantages to buying an annuity is that it can be a truly zero-maintenance investment strategy. Once you agree to the terms of an annuity contract, you can get steady income for life, even if you live for 50 years after you retire.
This is a rare quality, even among seemingly "set it and forget it"-type investments. For example, you can create a reliable income stream by purchasing 30-year Treasury bonds with your savings, but there's always the possibility that your retirement will last for more than 30 years.
5. Certain riders are appealing
When you purchase an annuity, you may have the opportunity to add riders to the contract, which is an insurance term that refers to the addition or subtraction of something from a policy.
As one example, long-term care (LTC) insurance has become prohibitively expensive for many retirees. A potential solution to this problem is to add an "LTC double benefit" rider to an annuity, which doubles your agreed-upon monthly income in the event that you need LTC services.
Common riders include cost-of-living (inflation-protection) riders and refund riders, which guarantee a minimum total payout from the annuity or a lump sum paid to your estate. If a rider offered by an annuity is particularly appealing or useful in your situation, it could make the annuity a far more attractive option.
Carefully weigh the pros and cons
Money manager Ken Fischer says, "Anything you want to do with annuities, there's a better way to do." And there's truth to that statement, mainly because of the widespread availability of low-fee investment alternatives which can generate income streams of their own.
The bottom line is that while annuities can be appropriate in many situations, that still doesn't necessarily make then the best option for you. It's important to evaluate your alternatives and weigh the pros and cons of each before using your retirement nest egg to buy an annuity.