Does an annuity make sense if you don't have a high net worth?

Annuities have long been touted as a reliable way to generate income in retirement. But the upfront cost of an annuity can deter some people who believe they need a substantial net worth to make purchasing one worthwhile.

While it’s true that some annuities, especially those offering guaranteed lifetime income, require significant capital, there are other options available — including deferred annuities — that might be more accessible to people with lower net worths.

However, regardless of your net worth, all annuities carry serious risks, including high fees and a lack of access to your cash.

In this article, we’ll break down how annuities work, different funding options and if these financial products make sense for people with lower net worths.

Understanding annuities

Before diving into whether annuities make sense for everyone, it’s important to understand how these financial products work.

An annuity is a financial contract between you and an insurance company. In exchange for a lump sum payment or a series of payments, the insurer agrees to provide you with regular income payments, either immediately or at a later date.

There are two types of annuities that describe when payouts begin.

—Immediate annuities: An immediate annuity provides income payments within a year after you purchase one. The amount of income you receive depends on your age, the amount you invest and the type of annuity you choose. Immediate annuities typically require a large upfront lump sum to fund the contract.

—Deferred annuities: A deferred annuity offers income payments at a future date, often during retirement. They allow you to grow your investment over time by making periodic payments to the insurer.

Does it make sense to buy an annuity if you don’t have a high net worth?

For people with high net worths, annuities can be a strategic tool to generate guaranteed income, defer taxes and protect their assets. Annuities can also be used to hedge against market volatility and provide peace of mind in retirement.

However, for people with lower net worths, it’s crucial to weigh the potential benefits, like a paycheck in retirement, against the risks and costs. For example, if buying an annuity would significantly deplete your savings, leaving you vulnerable to unplanned expenses, an annuity isn’t a good fit.

Likewise, it’s difficult to access money in an annuity, especially once payments begin, and many products carry hefty surrender charges or other features that penalize access to your money.

All of this matters because many annuities require a big upfront sum to get started.

“Unless someone has a few hundred thousand dollars, annuities probably aren’t going to be the best option,” says Joe Conroy, a certified financial planner and owner at Harford Retirement Planners. “People with less than that would probably be better off keeping it in a more liquid portfolio.”

Generally, Conroy and other experts recommend allocating no more than 25%-35% of your net worth to an income or immediate annuity.

“If you have a net worth of maybe $500,000 and up, then it might make sense to look at annuities,” says Conroy.

While immediate annuities might be out of reach for people with lower net worths, deferred annuities might be presented as a more viable option. These products often have lower minimum investment requirements, so funding the contract doesn’t require a huge amount of money.

But like all annuities, deferred annuities aren’t perfect, and many financial advisers don’t think they’re a good alternative to immediate annuities.

“Personally, I find it unappealing to be locking in lifetime income terms when we have no idea what kind of inflationary environment we’ll be in down the road,” says Scott Witt, an actuary and fee-only insurance adviser at Witt Actuarial Services.

Deferred variable and indexed annuities might promise to protect your funds from market downturns — but these protections also limit your returns.

“For someone who is already on the lower end of the wealth spectrum, I think they need to look for better ways to maximize their situation,” says Witt.

These are some other ways to save for retirement, even if you don’t have a high net worth.

—401(k) plan: If your employer offers a 401(k) plan or similar retirement account, you can enjoy tax deferred growth on your investments with minimal fees. You have more control over your investments than with an annuity and can build and manage your portfolio however you like. Additionally, many employers offer matching contributions to 401(k)s, which is essentially free money for your future.

—Roth IRA: Unlike qualified annuities or traditional IRAs, Roth IRA withdrawals are tax-free in retirement. You also get to choose from an even wider selection of investments, including stocks, mutual funds, bonds and ETFs. You can open a Roth IRA at top brokerage companies with no minimum requirements or ongoing account maintenance fees.

—CD ladder: A CD ladder is a strategy of investing in a series of certificates of deposit with staggered maturity dates to provide a steady stream of income. You can choose different maturity dates for each CD, allowing you to access your money on a set schedule without incurring penalties. While this strategy won’t provide you with guaranteed income or death benefits for your heirs, CDs and fixed annuities often offer similar rates of return, and CDs generally don’t charge commissions or ongoing fees.

Finally, annuities are often sold by insurance brokers or agents who earn a commission on the sale. That means they have a financial incentive to get you to purchase an annuity — even if it’s not a perfect fit. So beware of unscrupulous agents who try to pressure you into making unrealistic investments you can’t afford or purchasing long-term deferred annuities when you might need access to your money in the short-term for health care or living expenses.

Benefits of annuities

Deferred annuities, sometimes called accumulation annuities, may provide some benefits, depending on your specific situation.

Some of the top benefits of annuities include:

—Guaranteed income: One of the biggest advantages of annuities is the guaranteed income they can provide. This can be especially valuable if you’re concerned about outliving your savings in retirement.

—Tax-deferred growth: Annuities offer the potential for tax-deferred growth, meaning you won’t pay taxes on the earnings generated by the annuity until you withdraw money or begin receiving payouts.

—Protection against market volatility: Certain annuities, specifically fixed annuities which earn a set rate of return, can help protect your retirement savings from market fluctuations.

Drawbacks of annuities

While annuities offer some benefits, they’re not suitable for everyone — whether you have a high net worth or not. Annuities, especially variable annuities, are complicated and packed with fees. You can likely find investments offering high returns with easier access to your money in case of an emergency elsewhere.

Here are more details on the downsides of annuities.

—High fees: Annuities often come with high fees, including surrender charges, mortality and expense risk charges, and administrative fees. These fees can total 1% to 3% per year, significantly eating into your returns over time.

—Lack of flexibility: Once you purchase an annuity and begin receiving payouts from the insurer, it can be extremely difficult to make changes to the contract or withdraw your money without penalty. This lack of liquidity is a huge disadvantage if you don’t have other accounts or cash you can tap in case of an emergency.

—Potential for underperformance: If you choose an annuity with a low fixed interest rate or poor investment performance, you may not earn a competitive return.

—Complexity: Annuities are some of the most complicated financial products out there. While the detailed terms are outlined in the purchase paperwork, understanding it can be challenging if you don’t have legal expertise. This complexity can lead to misunderstandings and potential financial pitfalls.

Is an annuity right for you?

Whether or not an annuity is right for you depends on your specific financial situation, risk tolerance and retirement goals.

You’ll want to evaluate your overall financial health and determine how an annuity might fit into your broader retirement strategy. If you have a substantial net worth and are seeking a guaranteed income stream, an annuity might be a suitable addition to your portfolio. But if your financial resources are strained, you’re better off exploring other investment options.

Speaking with a financial adviser is a smart move if you’re considering purchasing an annuity. A fiduciary financial adviser, registered with the SEC, is legally obligated to act in your best interest and can’t sell you a product that’s harmful to your financial well-being. A fee-only adviser can also assess your specific circumstances, evaluate your options and recommend the best approach to meet your retirement goals.

Bottom line

Annuities aren’t suitable for everyone. While deferred annuities are more accessible to people with lower net worths, they still carry substantial risks, including locking up your funds. That might not be a major concern for someone with multiple sources of retirement income, such as retirement plans and real estate income. But for someone with a small nest egg, it can be detrimental.

By carefully considering the potential benefits and drawbacks, and consulting with a financial adviser, you can determine if an annuity is the right choice for your retirement portfolio.