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

While it is true that some annuities, especially those with guaranteed lifetime income, require significant capital, there are other options available – including deferred annuities – that may be more accessible to those with lower net worth.

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

In this article we explain how annuities work, different financing options and whether these financial products make sense for people with lower assets.

Understanding annuities

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

An annuity is a financial agreement 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 periodic 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 one year of purchasing 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 sum to fund the contract.

• Deferred annuities: A deferred annuity provides income payments at a future date, often during retirement. This allows 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 high net worth?

For high-net-worth people, 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 those with lower net worth, it is crucial to weigh the potential benefits, such as a salary in retirement, against the risks and costs. For example, if purchasing an annuity would significantly deplete your savings, leaving you vulnerable to unplanned expenses, an annuity is not appropriate.

Likewise, it’s difficult to access money in an annuity, especially once payments begin, and many products come with high surrender charges or other features that hinder access to your money.

This is all important because many annuities require a large amount of money upfront to get started.

“Unless someone has a few hundred thousand dollars, annuities are probably not 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 holding it in a more liquid portfolio.”

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

“If you have a net worth of perhaps $500,000 or more, it may make sense to look at annuities,” says Conroy.

While immediate annuities may be out of reach for those with lower net worth, deferred annuities can be presented as a more viable option. These products often have lower minimum investment requirements, so financing the contract does not require a huge amount of money.

But like all annuities, deferred annuities are not perfect, and many financial advisors don’t think they are a good alternative to immediate annuities.

“Personally, I find it unattractive to set lifetime income terms when we have no idea what kind of inflation we will be in in the future,” says Scott Witt, an actuary and fee-based insurance advisor at Witt Actuarial Services. .

Deferred variable and indexed annuities may promise to protect your money against market downturns, but this protection also limits your returns.

“For someone who is already at the bottom of the wealth spectrum, I think he should look for better ways to maximize his situation,” Witt says.

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 a similar retirement account, you can enjoy tax-deferred growth on your investments at minimal cost. You have more control over your investments than with an annuity and can build and manage your portfolio the way you want. 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 in retirement are tax-free. You can also choose from an even wider selection of investments, including shares, mutual funds, bonds and ETFs. You can open a Roth IRA at the top brokerage firms with no minimum requirements or ongoing account maintenance fees.

• CD ladder: A CD ladder is a strategy that involves 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, so you can access your money on a regular schedule without having to pay penalties. Although this strategy does not provide you with guaranteed income or death benefits for your heirs, CDs and fixed annuities often offer similar returns, and CDs generally do not 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 push you to buy an annuity, even if it isn’t a perfect fit. So beware of unscrupulous agents who try to pressure you into making unrealistic investments you can’t afford, or into buying long-term deferred annuities when you may need short-term access to your money for healthcare or livelihood.

Benefits of annuities

Deferred annuities, also called accumulation annuities, can offer certain benefits depending on your specific situation.

Some of the key benefits of annuities include:

• Guaranteed income: One of the biggest benefits 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 deferred growth, which means you don’t pay taxes on the income generated by the annuity until you withdraw funds or start receiving payouts.

• Protection against market volatility: Certain annuities, especially fixed annuities that provide a fixed rate of return, can help protect your retirement savings from market fluctuations.

Disadvantages of annuities

While annuities offer some benefits, they are not for everyone, whether you have a high net worth or not. Annuities, especially variable annuities, are complicated and loaded with costs. You’ll likely find investments that offer high returns and easier access to your money in the event of an emergency elsewhere.

Here you will find more information about the disadvantages of annuities.

• High costs: Annuities often have high costs associated with them, including surrender charges, mortality costs, expense risks and administration costs. These fees can total 1 to 3 percent per year, significantly eroding 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 major disadvantage if you don’t have other accounts or cash to tap into in an emergency.

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

• Complexity: Annuities are some of the most complicated financial products available. Although the detailed terms are outlined in the purchase paperwork, it can be difficult to understand if you don’t have legal expertise. This complexity can lead to misunderstandings and potential financial pitfalls.

Is an annuity something for you?

Whether 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 substantial assets and are looking for a guaranteed income stream, an annuity may be a suitable addition to your portfolio. But if your financial resources are under strain, you may want to explore other investment options.

Speaking with a financial advisor is a smart move if you’re considering purchasing an annuity. A fiduciary financial advisor, registered with the SEC, is required by law to act in your best interests and may not sell you a product that is harmful to your financial well-being. A fee-only advisor can also assess your specific circumstances, evaluate your options and recommend the best approach to achieving your retirement goals.

In short

Annuities are not suitable for everyone. While deferred annuities are more accessible to people with lower net worth, they still come with significant risks, including tying up your money. That may not be a major concern for someone with multiple sources of retirement income, such as pension plans and real estate income. But for someone with a small nest egg it can be harmful.

By carefully weighing the potential pros and cons and consulting a financial advisor, you can determine whether an annuity is the right choice for your retirement portfolio.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.