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As more people approach retirement, they’re looking for ways to reduce risk while still maintaining some opportunity for growth. That often leads to questions about annuities and whether they’re a good investment. The answer, of course, depends on your specific situation, goals, income needs, risk tolerance, and time horizon.

In this episode of Money Wisdom, Nicholas J. Colantuono, CFP® and Eric Hogarth, CFP® aim to set the record straight on annuities, helping to clear up confusion and provide clarity on your options.

What Is an Annuity?

Over the years, the general perception of annuities has changed dramatically. A few decades ago, annuities would often elicit an immediate negative reaction. Today, it’s much more common for people to ask whether an annuity might make sense for them.

At its core, an annuity is a contract issued by an insurance company. Like any investment, it is important to have realistic expectations and an understanding of the pros and the cons.

An annuity can be an effective tool if you value security and want to reduce some uncertainty around market volatility. However, they often cause confusion, mainly because there are several different varieties, each with their own distinct features.

Fixed Annuities

A traditional fixed annuity provides a guaranteed rate of return for a specified period. They’re similar to a certificate of deposit (CD), although not a bank product nor FDIC insured. 

For instance, you might commit your money for five years and receive a guaranteed 5% interest rate during that period. The advantage is predictability and safety. But the drawback is that you cannot access your money for a set period. Also, if interest rates rise after you’ve locked in your rate, you won’t benefit from those higher rates.

Another advantage is tax-deferred growth. Unlike CDs or traditional savings accounts, you don’t receive a taxable 1099 each year on the interest earned. However, the tradeoff is that when you begin taking distributions, you generally pay taxes on earnings as ordinary income.

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Variable Annuities

Variable annuities are quite different, as they introduce market risk and generally carry ongoing fees. The intention behind them is to provide greater growth potential. However, because fees can be significant, you need to consider whether the benefits justify the additional cost.

If growth is your main goal, you may want to consider a simpler market-based investment with lower fees. It may reach the same goal more efficiently. Variable annuities can sometimes offer valuable income features, but it’s important to evaluate them objectively.

Fixed Indexed Annuities

Fixed indexed annuities combine elements of safety and growth. The “fixed” portion means that you cannot lose money because of market declines. The “indexed” portion means your returns are somewhat linked to a market index such as the S&P 500.

The way they typically work is that you participate in a portion of the market’s gains while avoiding market losses. For example, if the market rises by 10% in a year, your annuity may get 6% or 7%. You don’t receive all the upside, but if the market declines 10%, your account does not lose value because of that decline.

The tradeoff is you give up some growth potential in exchange for protection against losses. For many retirees, that’s an attractive proposition because it offers more opportunity for growth while still preserving principal. 

The Bottom Line

Ultimately, the question isn’t whether annuities are a good or a bad investment. The question is whether a particular type of annuity is appropriate for your specific goals and circumstances. The real value comes from knowing how each tool works and how it fits into your broader retirement plan.