An annuity, which allows individuals to pay upfront or over time to receive a consistent income stream, is a popular source of retirement income for many. However, annuities also come with some drawbacks, including high commission fees and complicated contracts.

Annuities may or may not be a good investment for you, but there are some key warning signs to be aware of when shopping around. 

5 warning signs of a bad annuity

An annuity is a financial contract, typically with an insurance company, that promises to pay a guaranteed income stream over time in exchange for what you originally paid upfront, either through a series of payments or a lump sum. 

There are a few different types of annuities to choose from — including variable, fixed and indexed, to name a few — and each have their own advantages and disadvantages. In general, though, there are things to avoid when looking to purchase an annuity. Here are five warning signs of a bad annuity.

1. The fees are too high.

Annuities tend to have a slew of fees that may be charged annually based on the value of your annuity. Variable annuities and indexed annuities usually have the highest fees and commissions, while fixed annuities and immediate annuities have the lowest. 

The typical fees associated with annuities are as follows:

  • Commissions (1 percent to 8 percent)
  • Administrative fees (0.3 percent)
  • Surrender charges (0 percent to 10 percent)
  • Mortality expenses (0.5 percent to 1.5 percent)
  • Expense ratios (0.06 percent to 3 percent)
  • Riders (0.25 percent to 1 percent)
  • Rate spreads (2 percent)

The total cost of an annuity depends on what kind you get and the specific details of your contract, but the above fees are generally what you should expect to pay. 

If the numbers included in the annuity contract that’s proposed to you are far outside these ranges, consider walking away, as it could indicate excessive costs that might significantly reduce your returns or make the annuity less beneficial compared to other options.

2. The annuity is poorly managed.

Historically, annuities have been associated with high sales commissions for the brokers that sell them. These commissions create an incentive for agents to push for sales, even if an annuity isn’t necessarily the best choice for an investor.

Additionally, look for signs that include a lack of transparency in reporting the fund’s performance, poor communication from the fund manager and difficulty accessing customer service. In general, if the annuity’s underlying investments are unstable, extremely volatile or risky for your personal financial goals — or if the company managing it has a poor financial rating — those are also factors to consider that indicate poor management. 

3. There’s a long surrender charge period, or the charge is too high.

Most annuity companies allow you to cash out if needed, also known as a surrender, the contract for its current value, or take out a portion of the accumulated funds before income payments begin.

However, this will result in a surrender charge being deducted from the amount you receive. It’s not uncommon for surrender charge periods to last six to eight years from the purchase date of the annuity. These charges can be large, often around 7 percent or higher in the beginning of the contract, and then decrease as the surrender period progresses. 

If you notice that the annuity you’re looking to purchase has a surrender charge period longer than 8 to 10 years, or a fee higher than 7 percent, it’s a sign of a bad annuity and indicates the contract is more restrictive than other options.

4. The annuity has poor returns compared to other investment options.

Both variable and indexed annuities have underlying investments that are tied to market performance, meaning the value of your annuity can rise or fall based on how the investments selected perform.

  • Variable annuities offer a payout linked to the performance of the underlying investments, such as stocks and bonds (or both). 
  • Indexed annuities offer payouts based on an index such as the S&P 500 or Dow Jones Industrial Average. 

Be sure to take a look at how the annuity has performed over time. Comb through the returns of the mutual fund-like subaccounts. In fixed or indexed annuities, research and review the credited interest or returns linked to an index. You can find this information in the annuity’s prospectus or the quarterly statement provided by the insurance company.

Keep in mind that if you can’t easily find this information, that’s also a sign of a bad annuity. Most companies keep the performance data on their websites, too. 

5. The income agreements are vague or unclear. 

If the contract itself is extremely complicated and the payout agreement is vague or unclear, that’s a red flag. If you read through the contract and notice that the income you’ll receive, when you’ll receive it and under what conditions aren’t explained well (or not even mentioned), you should pass.

Annuities are notorious for their ambiguity when it comes to complicated wording. So while a contract may be difficult to understand, there’s a difference between complicated language and purposefully excluding important information about your potential income associated with the annuity.

Some examples include: The contract doesn’t clearly state how the income will be calculated, how factors will influence performance and whether the income is guaranteed for life or not. 

Bottom line 

Annuities are complex and may not be a good investment for everyone. There are pros and cons you may want to explore with a financial advisor who can understand your financial goals and long-term investing strategies. That said, there are several warning signs to pay attention to when it comes to determining whether an annuity is a poor option, like whether the contract is excluding important information or the fees are outrageous compared to other annuities out there.