The Pros and Cons of Annuities

Kevin Dyreson is a senior director of Insurance Solutions at Northwestern Mutual. 

A lot changes when you retire. Perhaps one of the biggest differences from your working years is that it's often on you to figure out how to create the retirement income you’ll need to live. And there are a lot of moving parts when it comes to creating that paycheck. In retirement, it’s common to generate regular income from multiple sources, including Social Security, pensions, retirement accounts or other savings.  

An additional financial option that may be worth considering is an annuity. Annuities come in different forms, but generally they are designed to help save for retirement and to create guaranteed income in retirement that you can’t outlive. 

While annuities can be a great tool as part of a larger retirement income plan, everyone’s situation is unique. Here we’ll look at the pros and cons of annuities to help you get a better sense of whether an annuity is right for you.  

The pros of annuities  

An annuity can be a helpful financial tool to add to your plan. Here’s why:  

You have options, depending on your timeline.  

Whether you’re about to retire or just starting to think about saving for retirement, there are different types of annuities that might be right for your situation. 

If retirement is still years away, you could opt for an accumulation annuity, which allows you to save money tax-deferred that can be used to provide income when retirement arrives. If you’re nearing retirement or just about to retire, you may want to consider an income annuity, which will start making income payments to you a few months or a few years after you purchase it from the insurance company (exactly when you want your income to start is entirely up to you).   

As you hit key retirement milestones, it can be a good time to pause and consider whether you have the right financial tools in place or you should make adjustments. 

You have options, depending on your risk tolerance. 

Accumulation annuities can be either fixed or variable, which can be a way to get an annuity that’s aligned to your risk tolerance. The money inside a fixed annuity grows at a fixed interest rate. But if you’re willing to take on more risk, you could opt for a variable annuity, which allows you to allocate your funds across subaccounts, which can give you exposure to market returns. 

If the subaccounts perform well, your retirement savings will grow. But it’s possible to lose money in a variable annuity if your subaccounts perform poorly.  

You can use qualified and nonqualified dollars. 

Qualified and nonqualified refer to the way money you earn in a given year is treated from a tax perspective. Qualified dollars “qualify” for special tax treatment, so those contributions are considered pre-tax (like the contributions you make into a 401(k) or an IRA). Nonqualified money refers to dollars you’ve already paid income tax on, so they are considered after-tax dollars.  

You can put both qualified and nonqualified dollars into an annuity. 

If you’re using nonqualified dollars, there is no limit to the amount you can contribute. If you’re purchasing an annuity with qualified dollars, you’ll be subject to IRS limits on your contributions—these are the same limits you’d face if you were investing your contributions in mutual funds or other financial products. 

However, annuities can provide some additional benefits. One such example is a qualified longevity annuity contract (QLAC), which allows you to delay required minimum distributions. 

Your money grows tax-deferred.  

It doesn’t matter if your contributions are qualified or nonqualified; your money will grow tax-deferred in an accumulation annuity. This means that your investment gains will compound more over time than if they were taxed along the way (assuming identical rates of return). 

You can get guaranteed income for life.  

When you live off your savings in retirement, you take the risk that you could live too long or lose money in the market and eventually run out of money. If you worry about outliving your savings, you’re not alone. In fact, the 2024 Northwestern Mutual Planning & Progress Study found that 43 percent of Americans worry they could outlive their savings. Income annuities help protect against this by providing guaranteed payments for the rest of your life—no matter how long you live. 

The cons of annuities  

An annuity can bring a lot of benefit to your financial plan, but annuities aren’t for everyone. Here are some cons of annuities to consider:  

You may pay higher fees for accumulation annuities than for some other types of investments.  

When compared with fees you pay for mutual funds, index funds or other investments, some accumulation annuities charge higher fees, often due to the optional benefits and guarantees they may provide. Carefully discuss these optional benefits and guarantees with your financial advisor to determine which ones are worth the cost.  

You may have to pay a surrender charge to withdraw money from an accumulation annuity.  

 If you decide to withdraw your money in the first few years after purchasing an accumulation annuity, you may have to pay a surrender charge. After a certain number of years (usually five to 10), surrender charges will no longer apply. However, you may still have to pay taxes and penalties to the IRS if you withdraw your money before age 59½ from a qualified annuity.  

You may not be able to change your mind once you buy an income annuity.  

Income annuities provide guaranteed income for life but are often nonrefundable, which means you can’t take the lump sum of money back after you purchase them (the money is repaid through the regular payments over the course of your life). Therefore, it’s important not to put all your eggs in one basket (i.e., keep some money in investments, savings accounts or CDs as well). Annuities work best when they’re a part of a larger retirement picture.  

You may not get all your money back from an income annuity if you die early.  

When you purchase an income annuity, income payments often continue for as long as you live. If you die early, you may receive less in income than you initially paid to purchase the annuity. However, many income annuities offer a feature called a “period certain,” which guarantees that a certain number of payments will be made to you or your beneficiaries, even if you die early. Many income annuities also offer a “cash refund” option, which guarantees that a lump sum will be paid out to your beneficiaries when you pass away if you have received less in income than you paid for the annuity.  

Deciding whether an annuity is right for you 

If an annuity sounds like it might be a fit for you, reach out to your financial advisor to learn more about the different types of annuities and how they might work with your other assets to help you reach your financial goals. Your advisor can also help you identify other opportunities and blind spots to grow and protect your money as you work toward your financial goals.  

Guarantees in an annuity are backed solely by the claims-paying ability of the issuer.  

The performance of variable funds and underlying investment options are not guaranteed and are subject to market risk, including loss of principal.  

Withdrawals from annuities may be subject to ordinary income tax, a 10 percent IRS penalty if taken before age 59½, and contractual withdrawal charges.