Many investors nearing retirement age depend on payments for a fixed annuity to live comfortably in their later years. However, like all investments, there are disadvantages of a fixed annuity.
Some of the things investors need to be conscious of when buying a fixed annuity include penalties for withdrawing funds before the age of 59 ½, surrender charges for withdrawals more than the yearly 10 percent surrender-free withdrawal allowance, the potential that the investment vehicle will not keep up with inflation rates, earnings could be less than the current payouts for variable rate annuities, and a lack of investment enthusiasm because earnings are set.
Find out more about the disadvantages of fixed annuities in this guide, with valuable information on alternatives for investors who want to receive regular income from their investments.
What are the Disadvantages of a Fixed Annuity?
Many investors and financial advisors recommend fixed annuities for people close to retiring and those with a low-risk threshold. Nevertheless, while fixed annuities provide some security, they also have several disadvantages. So, before redistributing the funds in your 401k, read the cons of fixed annuities below.
You are responsible for paying penalties when receiving payouts from a fixed-rate annuity before you turn 59 ½. The penalties can quickly eat away any gains you receive by owning the annuity.
So, if you own or plan to buy a fixed annuity, you must choose one that starts paying you after you reach the minimum age for fee-free withdrawals.
2. Surrender Charges
Surrender charges are fees you have to pay when you withdraw funds before the minimum age allowance or above 10 percent of the value of your initial investment even after you are 59 ½.
The penalty or surrender charge for withdrawing funds starts at up to 10 percent for the money you withdraw within the first 12 months and drops by one percent each subsequent year.
3. Maturity May Not Keep Up With Inflation
While it is great to have a source of fixed income after you retire, the payments you receive from a fixed-rate fund are set in advance. So, you may purchase an annuity with a fixed return of $1,000 per month, thinking that will be enough to supplement your living expenses.
However, if you purchase a fixed annuity with a term of 20 years, the payments may be more than enough to cover your expenses early in the investment period. However, as the cost of living and inflation rises, you may find that the annuity payments are insufficient.
4. Limited Earning Potential
A fixed annuity begins paying you back for your initial investment as soon as the annuity date begins. However, your returns are set forth when you make your initial investment, and they do not increase. So, you will not have the opportunity to earn as much when the stock market is thriving.
5. Lack of FDIC Coverage
Fixed annuities do not have coverage from the FDIC. That means you have no protection if the insurance company that sold you the annuity goes out of business or loses your money.
Fixed Annuity Alternatives
There are plenty of alternatives to fixed annuities that you can purchase to diversify your retirement portfolio. Your investment goals, finances, and lifestyle all impact your investments. So, consider these investment types if you do not feel that fixed-rate annuities do not meet your investment goals.
1. Variable Annuities
Fixed-rate annuities pay the same earnings throughout the investment period. Once the initial investment period ends, the annuity company will present you with a renewal rate that may be higher or lower than your initial returns.
With variable-rate annuities, your earnings rise and fall depending on the performance of the market. Purchasing variable-rate annuities can be riskier than the fixed-rate option. However, you have a higher potential for earnings when the stock market is thriving.
2. Indexed Annuities
The performance of indexed annuities is directly tied to the index backing them. So, if you have an S&P-indexed annuity, the payouts depend on the health of that stock exchange.
3. Immediate Annuities
Immediate annuities start paying you as soon as you make your initial investment. The length of the payments depends on the type you choose. Immediate annuities are available with payments for different term lengths. Usually, the larger your initial investment and the shorter the term, the greater the payments.
4. Deferred Annuities
Deferred annuities are an excellent option for investors with more time before retirement and a higher risk threshold. When you invest in deferred annuities, you often receive higher payouts in the future.
However, the payment size depends on how well the annuity does during the deferral period. If the annuity underperforms, your payments may go down. So, deferred annuities are riskier than fixed or immediate options, but you may also receive higher returns.
5. Exchange Traded Funds (ETFs)
Exchange-traded funds (ETFs) are another option for investors who want to purchase assets that have a lower risk. There are numerous ETFs you can choose between. Some follow specific stock sectors or industries, while others are more diversified. However, ETFs can own less than 25 or more than 7,000 stocks.
ETFs do not guarantee a specific investment return. However, you do earn dividends at regular intervals.
6. Mutual Funds
Mutual funds are another low-risk investment. They are operated by financial management brokers that collect payments from investors. The collected investments are used to purchase stocks.
The fund manager handles the purchasing and sale of assets and pays shareholders based on the performance of the stocks in the fund. Unlike individual stocks, mutual funds are more diversified, reducing your risk if one or a few of the holdings perform poorly.
Final Advice on Disadvantages of a Fixed Annuity
Many financial planners and money managers suggest fixed annuities to workers close to retiring. However, the disadvantages of a fixed annuity mean they are not suitable for everyone. If you do not need regular payments from your investment until you reach 59 1/2 and do not plan to withdraw more than 10 percent of your initial investment each year, a fixed payment annuity may be a great option. However, you may receive higher payouts if you opt for a variable-rate annuity, ETF, or mutual fund.
Each person has a different financial situation and investment goals. You need to evaluate your specific situation before you purchase assets, especially if you are close to retiring because losing money or making a bad investment after you no longer have an income can be catastrophic. If you are unsure what product is right for you and your short and long-term goals, it is a good idea to hire a financial planner who can assist you in purchasing assets that will grow and offer you long-term income after you retire.
For help with other financial matters, like credit card forgiveness for seniors, read the other guides on our site.