Editor's Note: This story originally appeared on SmartAsset.com.
Annuities are popular financial products that often guarantee income throughout the course of your retirement.
While you may even have access to customizable features and riders, you’ll likely have to pay high fees and may also end up taking home less than you would by investing your money elsewhere.
Note that those who sell annuities often receive extremely high commissions for doing so, though. If you’re thinking about an annuity and crafting a retirement plan, consider speaking with a financial adviser.
Here’s how annuities work, and how to decide whether they’re for you.
What Is an Annuity?
Simply put, an annuity is a financial contract between an insurance company and an individual that allows the individual to pay money now in exchange for a guaranteed and steady stream of income in the future. The individual who has the annuity either pays for it all upfront or in a series of regular payments.
As the names would suggest, an immediate annuity begins paying out right away, while a deferred annuity begins paying out after a certain amount of time.
Annuities can also use a different structure depending on the needs of the individual. They can pay out over the course of a lifetime, or they can pay out for just a set amount of time.
There are also two other annuity structures: fixed and variable. With a fixed annuity, the rate of return for the individual investor is set and won’t fluctuate throughout the life of the annuity.
Some fixed annuities can be indexed to a specific index fund or market index as well.
When it comes to a variable annuity, the insurance company you buy the annuity from will invest your money in different funds and accounts, paying out based on the performance of those funds and accounts.
You can also be in control of the investments in your annuity if you have a variable contract. On the other hand, it can also be riskier in the case of a market downturn.
Is an Annuity a Good Investment?
There are a number of very valid criticisms about annuities, but it’s worth noting that there are a few potential upsides that could benefit you, depending on your financial situation and financial goals.
First and foremost, an annuity guarantees your income. Even in the event of a market downturn, the insurance company must pay you the amount agreed upon in the contract, which makes an annuity a very stable investment.
However, if the insurance company goes out of business, you may not get anything. In turn, it’s important to only work with insurance companies that are reputable and stable.
Another reason why an annuity may be a good investment is that they often come with customizable money management features. You can add things like minimum income benefits that guarantee a certain regular payout, even in the event of a market downturn.
You can also add a spousal provision that allows payments to continue when you die as long as your spouse is still living. On that note, a death benefit provision allows dependents of the annuity to receive a payout upon the annuitant’s death.
An annuity typically isn’t the best investment if you’re just using it to retire on its own. However, in specific instances, it may be a great addition to your overall retirement plan.
For example, if you’ve already maxed out your other retirement account options, an annuity can provide another option. An annuity may also be a strong idea if you come into a large sum of money.
In this case, an annuity can help you avoid having the option of spending it too quickly. In this case, you may want to think about an annuity that pays out over a set amount of years.
Why Annuities Can Be a Bad Investment
Annuities are often the subject of heavy criticism. This is mainly because they can provide subpar returns when compared with relatively simple investment strategies.
Those using a deferred annuity as the primary option for financing their retirement, for example, will almost certainly be better off first investing in an individual retirement account (IRA) or a 401(k).
These other retirement accounts provide similar, if not better returns, and don’t carry the same fees.
One of the largest drawbacks of annuities is the fact that you’ll pay high fees in comparison to similar products. While fees differ between insurance companies, you’ll usually end up paying more than you would investing in funds.
There are also usually maintenance charges and operational charges that you’ll have to pay. This obviously adds to the cost and decreases what you end up with in your pocket.
Plus, the commissions for financial advisers and brokers are higher than they are for other retirement accounts. In fact, they can typically be in the realm of 7%.
As a result, it’s easy to see why salespeople would direct clients towards annuities as retirement income streams.
Annuities may also subject owners to surrender charges. These come about if they need to withdraw money from the annuity before several years have elapsed.
Additionally, since annuities are tax-deferred, you may be charged a 10% early withdrawal penalty. However, these drawbacks may also be true for other retirement accounts as well.
Annuities are a polarizing topic. But whether one is a good investment for a particular person ultimately depends on a number of factors. These include your age, your current retirement savings, your goals for the future and more.
There are certainly drawbacks to annuities because of their fees and relative inferiority to other retirement accounts. However, you still may decide that an annuity is a good investment for you.
If you’re already maxing out other retirement accounts or you want to distribute a lump sum over a longer period of time, an annuity can be a good idea. Otherwise, you may be best off looking for retirement investments elsewhere.