The Hidden Costs of Annuities

Why Fees, Commissions, Surrender Charges, Inflation Risk, and the Way Annuities Are Sold Matter Just as Much as the Guarantees They Promise

Annuities have gotten a bad reputation.

And, to be fair, some of that criticism is deserved.

I’ve been critical of annuities myself over the years. But the more important question isn’t whether annuities are “good” or “bad.”

That is too simplistic.

The better question is:

Does this particular annuity solve a specific problem in your financial plan and is it doing so at a reasonable cost?

Because the biggest problem with annuities often isn’t the product itself.

It’s how the product is sold.

Annuities can be oversold. They can be sold to the wrong people. And perhaps most importantly, investors can be encouraged to put far too much of their retirement savings into them.

On the other hand, there are situations where an annuity can provide something genuinely useful: a dependable source of retirement income, a way to cover essential expenses, or additional peace of mind for an investor who struggles with market volatility.

The key is understanding what you are buying, what it costs, what you are giving up, and exactly what problem the annuity is supposed to solve.

Why Annuities Get So Much Criticism

One of the reasons investors have such strong opinions about annuities is that the products can be complicated.

Different contracts may contain combinations of:

• Income benefits
• Withdrawal benefits
• Death benefits
• Investment subaccounts
• Surrender schedules
• Participation rates
• Caps
• Administrative expenses
• Mortality and expense charges
• Other contract-specific features and restrictions

That complexity makes comparison difficult.

It also means the most attractive feature in the sales presentation may not tell you nearly enough about whether the product is appropriate.

This is similar to a broader problem we have discussed in our series on financial advice red flags every investor should know.

When a financial product is complicated, investors need to look beyond the headline benefit and understand how everyone involved is being compensated, what restrictions exist, and what alternatives were considered.

Hidden Cost #1: Commissions

One of the biggest concerns with certain annuities is compensation.

Depending on the product and the professional selling it, an insurance company may pay a substantial commission to the salesperson or advisor when the annuity is purchased.

The investor may not write a separate check for that commission.

That does not mean nobody is getting paid.

The compensation can be built into the economics of the contract.

Why does that matter?

Because compensation can create a conflict of interest.

Imagine an advisor can recommend one solution that generates an ongoing advisory fee or another product that pays a much larger commission upfront.

The annuity may still be appropriate.

But as an investor, you deserve to know that financial incentive exists.

That is why one of the most useful questions you can ask is:

“How much will you personally be paid if I purchase this annuity?”

Then ask:

“Would you be paid differently if I chose another investment instead?”

Those questions can tell you a lot.

This compensation issue is one of the primary distinctions between commission-based advice and the fee-only fiduciary model.

At Libertas Wealth, our planning process begins with the client’s circumstances and financial objectives—not with a product that needs to be sold.

The product should come after the problem has been identified. Not before.

Hidden Cost #2: Internal Expenses

The commission is only one part of the equation.

Some annuity contracts can also carry meaningful internal expenses.

Depending on the type of annuity and the benefits selected, these may include expenses associated with the insurance contract itself, investment options, enhanced death benefits, income guarantees, withdrawal guarantees, or other riders.

Those expenses may not appear as one obvious line item.

That can make an annuity feel less expensive than it actually is.

Before buying one, investors should understand the complete economic cost of the contract.

Ask:

• What are the annual contract expenses?
• What do the underlying investments cost?
• Does the income rider have an additional charge?
• Is there a separate cost for an enhanced death benefit?
• Are there administrative expenses?
• How do those expenses affect the contract value over time?
• What happens to the benefits if I stop paying for a rider?

Do not settle for:

“There’s no fee.”

Financial products are businesses. Someone is being compensated somewhere.

The better question is:

“Walk me through every cost associated with this contract.”

Hidden Cost #3: Surrender Charges and Lost Liquidity

Another potential disadvantage is the surrender period.

Some annuities impose charges if an investor wants to leave the contract or withdraw more than the amount permitted during a specified period.

That matters because retirement rarely goes exactly according to plan.

You may need money for:

• A home purchase
• Medical expenses
• Long-term care
• Helping children or grandchildren
• A major renovation
• An unexpected tax bill
• Travel
• A business opportunity
• Another investment
• Changes to your estate plan

If a significant portion of your liquid net worth is locked inside a contract with surrender restrictions, those changes can become more difficult.

That doesn’t automatically make a surrender schedule unacceptable.

It simply means liquidity should be evaluated before the contract is purchased.

If you already own an annuity and someone recommends replacing it with another one, be especially careful.

As we explain in our discussion of financial-advice red flags, the end of a surrender period does not necessarily mean an annuity needs to be replaced.

Before exchanging one contract for another, ask what actually improves.

What benefits are you giving up?

Will a new surrender schedule begin?

What does the new contract cost?

And how is the person recommending the change being compensated?

So, Are Annuities Bad Investments?

No.

But they aren’t automatically good investments either.

That is the point.

An annuity should solve a problem.

And in my experience, one of the biggest mistakes in financial services is treating annuities as if they are the answer for every retiree and every dollar.

They aren’t.

There are situations where they may make sense.

There are also situations where they probably do not.

Let’s look at the difference.

When an Annuity Might Make Sense: Creating Predictable Retirement Income

One potential use for an annuity is creating a predictable source of retirement income.

Certain annuity contracts offer income benefits designed to provide payments over the investor’s lifetime, subject to the specific terms and claims-paying ability of the issuing insurance company.

For the right retiree, that can provide psychological and financial value.

Think of it somewhat like creating another income stream alongside Social Security or a pension.

The retiree knows a certain amount of money is intended to arrive regularly.

That can make budgeting easier.

More importantly, it may reduce the stress that comes from having every dollar of retirement spending depend directly on market performance.

Annuities Can Help Fill a Retirement Income Gap

Here is where this becomes more practical.

Imagine a retired couple receives:

• $25,000 per year from Social Security
• $35,000 per year from a pension

That gives them $60,000 of annual income.

Now imagine their essential fixed expenses are approximately $80,000 per year.

They have a $20,000 income gap.

Their mortgage or housing costs still need to be paid.

So do property taxes. Utilities. Groceries. Insurance. Healthcare.

Those expenses do not disappear because the stock market happens to be down.

One option would be to simply withdraw the additional $20,000 from their investment portfolio every year.

For many retirees, that may work perfectly well.

If they understand market volatility, have an appropriately constructed portfolio, maintain adequate liquidity, and are comfortable taking systematic withdrawals, there may be no compelling reason to add an annuity at all.

But another retiree may look at the exact same situation and lose sleep.

They may worry every time the market falls.

They may constantly wonder:

“What happens if I run out of money?”

For that investor, it may be worth evaluating whether using a portion of the portfolio to create additional predictable income could cover essential expenses and reduce financial anxiety.

Notice the emphasis:

A portion.

Not necessarily the entire portfolio.

Why “Some of Your Money” Matters

This is one of the most important points in the entire annuity conversation.

Even when an annuity makes sense, that does not mean all of your retirement money belongs in one.

Suppose someone has a $1 million investment portfolio and needs an additional $20,000 per year to cover essential living expenses.

Hypothetically, if a portion of the portfolio could be allocated to an appropriate income solution to fill that $20,000 gap, the remaining assets could continue serving other purposes.

Those remaining assets might provide:

• Long-term growth
• Inflation protection
• Emergency liquidity
• Travel money
• Vehicle purchases
• Gifts to children or grandchildren
• Future healthcare expenses
• Legacy assets

That is very different from saying:

“I’m nervous about the market, so put the whole million dollars into an annuity.”

The goal is not to eliminate every risk.

It is to assign different dollars different jobs.

That planning-first philosophy is central to our approach at Libertas Wealth.

When an Annuity May Help an Anxious Investor

There is also a behavioral component to consider.

Some investors simply hate market volatility.

They can intellectually understand that markets fluctuate and still feel tremendous stress every time their portfolio declines.

That matters.

Because an investment strategy only works if you can stick with it.

If normal market volatility repeatedly causes an investor to sell, move to cash, abandon a financial plan, or make large portfolio changes at emotional moments, the theoretically optimal strategy may not be optimal for that particular person.

We discuss this problem in more detail in Following Market Trends Without Letting Emotions Take Over, and our article on Behavioral Adherence During Volatile Markets.

For some conservative investors, knowing that a portion of their essential retirement income has been addressed may make it psychologically easier to leave the rest of the portfolio invested appropriately for long-term growth.

In that situation, the annuity isn’t necessarily being used because it promises the highest return.

It is being used to solve a behavioral and cash-flow problem.

That can be valuable.

The Overlooked Risk: Inflation

Here is where investors need to be careful.

A guarantee may protect the nominal amount of income.

It does not necessarily protect the purchasing power of that income.

Those are very different things.

Imagine you receive the same monthly income for many years.

Your payment hasn’t declined.

Sounds great.

But meanwhile:

• Groceries become more expensive
• Property taxes rise
• Insurance costs increase
• Healthcare gets more expensive
• Utilities increase
• Travel costs more
• Home repairs cost more

Your income technically stayed the same.

Your lifestyle became more expensive.

That is inflation risk.

We touched on this same issue in What Your Dad Got Wrong About Money – And What Today’s Retirees Should Do Instead.

Cash and guarantees can feel safe because the account balance or income stream does not fluctuate the way stocks do.

But avoiding volatility does not eliminate risk.

It changes the type of risk you are taking.

You Can “Go Broke Safely”

One phrase I’ve used over the years is:

You can go broke safely.

What does that mean?

It means an investor can become so focused on avoiding short-term investment losses that they put all of their money into investments or products that fail to keep pace with the long-term cost of living.

There are risks beyond stock-market risk.

There is:

• Inflation risk
• Interest-rate risk
• Longevity risk
• Liquidity risk
• Purchasing-power risk
• Sequence-of-returns risk

A financial plan has to balance them.

Something being “guaranteed” does not automatically make it appropriate.

Something fluctuating does not automatically make it dangerous.

Risk has to be considered in the context of what the money is supposed to accomplish.

What About Fixed and Indexed Annuities?

Variable annuities are only one part of the annuity universe.

There are also fixed annuities and multiple forms of indexed annuity contracts.

The details can vary substantially between products and insurance companies, but broadly speaking, different annuity structures may offer combinations of fixed rates, index-linked crediting methods, income benefits, downside protection features, caps, participation rates, spreads, and other contract-specific provisions.

And this is exactly why investors need to be careful.

A sales presentation can make a complicated contract sound incredibly simple.

You might hear something like:

“You participate when the market goes up, but you don’t lose money when it goes down.”

That sounds wonderful.

But it does not tell you:

• How much of the upside you receive
• Whether gains are capped
• How the index credit is calculated
• Whether dividends are included
• What the participation rate is
• How long your money is committed
• What surrender charges apply
• What happens if you need liquidity
• What the income guarantees actually cover
• What the contract costs economically

The headline is not enough.

You have to understand the fine print.

Six Questions to Ask Before Buying an Annuity

Before purchasing an annuity, I would want clear answers to at least these six questions:

1. What specific problem is this solving?

Is it creating income? Reducing behavioral risk? Providing a death benefit? Addressing longevity risk?

If nobody can clearly define the problem, you probably don’t need the product.

2. How much does it cost?

Ask for every contract expense, investment expense, rider charge, and other cost.

3. How is the person recommending it compensated?

Do they receive a commission? How much? Would another product pay them differently?

4. What happens if I change my mind?

Understand surrender periods, withdrawal limitations, and any potential penalties.

5. What am I giving up?

Liquidity? Market upside? Flexibility? Lower costs? Inflation protection?

Every financial product involves trade-offs.

6. Why this amount?

Even if the annuity makes sense, why should $100,000 go into it instead of $50,000?

Why $500,000 instead of $200,000?

Why 70% of the portfolio instead of 20%?

The allocation should be connected to the problem being solved.

Start With the Financial Plan, Not the Annuity

This is ultimately the biggest lesson.

Do not begin with:

“Should I buy an annuity?”

Begin with:

“What does my retirement plan need?”

How much will you spend?

How much guaranteed income already exists?

What will Social Security provide?

Do you have a pension?

How much liquidity do you need?

How much market volatility can you realistically tolerate?

What happens if you live longer than expected?

What happens if inflation is higher?

What happens if markets decline early in retirement?

What assets need to remain available for emergencies, healthcare, travel, family, or legacy goals?

Only after those questions are answered should the conversation turn to individual products.

An annuity may turn out to be part of the solution.

Or it may be completely unnecessary.

That is what comprehensive financial planning is supposed to determine.

Annuities Aren’t Good or Bad. They’re Tools.

A hammer is useful when you need to drive a nail.

It is not particularly useful when you need to tighten a screw.

Financial products work the same way.

The mistake is not using an annuity.

The mistake is buying one without understanding why you own it.

For some retirees, the costs, complexity, liquidity restrictions, and inflation concerns outweigh the benefits.

For others, dedicating a carefully selected portion of the portfolio to predictable lifetime income may significantly improve both the financial plan and their ability to sleep at night.

The answer depends on the investor.

The financial plan.

The contract.

The costs.

And the problem you are trying to solve.

That is why financial advice should begin with understanding your circumstances—not with selling you a product.

Already Own an Annuity? Get a Second Opinion

If you already own an annuity and aren’t sure exactly what you have, what you’re paying, or whether the contract still fits your retirement plan, it may be worth having someone take a second look.

Questions worth reviewing include:

• What benefits does the annuity provide?
• What are the actual costs?
• Is there still a surrender charge?
• What happens if you keep it?
• What happens if you leave it?
• Is the income benefit actually needed?
• Does the contract create an inflation problem?
• Is too much of your portfolio tied up in it?
• Would changing the contract improve your situation—or simply create another commission?

At Libertas Wealth Management Group, you never have to become a client simply to ask a question.

You can learn more about our fee-only fiduciary approach, take our quick compatibility assessment, or contact our team to schedule an introduction and get a second opinion.

Disclosure: This article is for informational purposes only and should not be considered legal, financial, tax, or investment advice, or a recommendation to purchase, sell, exchange, or retain any specific annuity or investment product. Annuity guarantees are subject to the terms of the applicable contract and the claims-paying ability of the issuing insurance company. Costs, features, surrender provisions, tax consequences, and benefits vary by product. Consult qualified financial, tax, and legal professionals before acting on any strategy discussed.

Disclosure: This article is for informational purposes only and should not be considered legal, financial, tax, investment, or insurance advice, or a recommendation for any product, transaction, professional, or business model. Professional standards, licensing requirements, compensation arrangements, and fiduciary obligations can vary by professional, service, account type, and jurisdiction. Consult qualified financial, legal, tax, and insurance professionals before acting on any strategy discussed.