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The 7 Drawbacks to Fixed Annuity Products

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Today’s fixed annuity products possess great intrinsic value (e.g., tax deferral, guaranteed income options, probate avoidance and others), but they come with drawbacks that a buyer must understand before committing their hard-earned cash.

In my view the drawbacks are not deal breakers but must be carefully considered by the buyer before the products are purchased.

The key fixed annuity product drawbacks are:

1. Interest Rates That Can Change Each Year

Most fixed annuity contracts (except for multiple year annuity products, where the interest rate is guaranteed for the entire surrender charge period) allow the issuing life insurer to set a new interest rate each year or period of years. This means that the interest rate the consumer receives can change during the surrender charge period. This is an implicit risk the consumer is taking when buying most fixed annuity contracts.

This impact of this drawback can be minimized by understanding the renewal rate history of the issuing life insurance company. Most all annuity companies will provide a documented record of their renewal rates as a historical indicator of how the carrier has treated consumers when setting renewal rates.

2. No Capital Gains Tax Rate

Income earned on fixed annuity contracts is treated as ordinary income and not as capital gain. For example, suppose a fixed annuity contract is purchased for $25,000 and the contract is fully surrendered 10 years later when its value is $50,000. Based on current tax law, the gain on the contract of $25,000 will be treated as ordinary income and taxed at ordinary income rates in effect at the time of withdrawal. The benefit of being taxed at likely lower capital gains rates is not available.

3. Contractual Bonuses That Come With Strings Attached

Many fixed annuity contracts are sold with what are advertised as first-year bonus interest of 3% to 5% for example. The buyer should know that for most contracts, to fully earn these bonuses, they will need to hold the contract for several years, or, in some cases, they will only get the bonus if they take an income stream from the contract.

4. Limited Access to Cash

Fixed annuity products are not checking accounts. They do, however, allow the consumer to withdraw money from the contract in many ways but with restrictions. The three most common ways contracts allow access to cash are 1) by a partial withdrawal from the contract, 2) a full surrender of the contract and 3) by taking payments based on one of the contract’s options or riders. If the consumer takes more than a certain percentage of the contract’s value (usually 10%), they will be subject to a surrender charge. Most annuities come with a surrender charge schedule that requires the buyer to pay a fee if they surrender the annuity contract in a certain number of years (i.e., typically 6 to 10 years) from purchase. These fees can be significant. So, it is hard to back out of a contract once purchased. Overall, consumers should only put money into an annuity contract that is being invested or saved for the medium to long-term.

5. Additional Taxes for Withdrawals Prior to Age 59½

If withdrawals are taken from a fixed annuity contract prior to age 59½, in most cases, an additional 10% penalty or tax will be due on withdrawn interest earned. Remember, annuities were intended to create supplemental retirement income and withdrawals prior to age 59½ trigger this penalty. There are some exceptions to this rule and consumers should consult their tax professional to get the specifics.

6. No Additional Tax Benefit for Qualified Funds

If a buyer funds their fixed annuity purchase with pre-tax or qualified funds, they do not receive any additional tax deferral benefit for doing so. Qualified funds are already tax deferred by law and, thus, get no additional income tax benefit by being placed into a fixed annuity. Many consumers buy annuities using qualified money, however, to obtain the basic benefits that annuities offer that other savings products do not, such as guaranteed lifetime income.

7. Complexity

One of the cardinal rules of saving and investing is not to buy a product you don’t understand. Annuities are no exception. Consumers need to be sure they understand the contract they are purchasing and its key features, benefits, costs and restrictions.

Fixed annuity contracts can be extremely valuable for the consumers who need them. They can provide guaranteed fixed rates of return, potential returns tied to investment market indices, protection of principal and guaranteed lifetime income in exchange for certain drawbacks or restrictions. They are a financial tool that can be used to create tax-advantaged returns and supplemental lifetime income. The key is for buyers to understand the drawbacks and to make sure the annuity products they buy fit their needs and risk tolerance.


Harry N. Stout (credit: Stout)Harry N. Stout has been the president of Fidelity & Guaranty Life, deputy chief executive of Old Mutual Financial Network, and managing director of Insurance Insight Group. He is also the author of The FinancialVerse personal finance books and of a new book, Today’s Annuities — A Tool to Create Protected Lifetime Income.

(Photo: Alexander Raths/Shutterstock)