5 questions you need to ask before buying an annuity

Buying an annuity is a major financial decision. You’re often tying up your money for a long time and, since many people use these financial products to fund their retirement, you’ll be relying on those payments for years to come, sometimes the rest of your life.

Before you make a commitment, understand exactly what you’re buying and how it works. Investing always involves risk, but asking the right questions can help you decide if an annuity is truly what you want and if it meets your needs.

5 questions you need to ask before buying an annuity

Here are five questions to ask your advisor or insurance agent before signing an annuity contract.

1. How much can I withdraw from an annuity annually?

Your annuity may offer a free withdrawal provision, allowing you to withdraw a percentage of its value each year without fees, usually 10 percent. Exceed this limit, and you could face hefty withdrawal fees or surrender charges.

Withdrawal provisions vary depending on the insurer and the type of annuity. Immediate annuities, for example, rarely allow withdrawals, while deferred annuities may offer access based on the contract terms.

Always check the tax implications on withdrawals too, since taxes and penalties can reduce the amount you receive. For example, withdrawals made before age 59 ½ may face a 10 percent penalty from the IRS.

2. Is an annuity a suitable investment for me?

Not everyone needs an annuity, and depending on your situation, an annuity could be a bad investment. Suitability generally depends on factors such as your age, income needs and financial goals.

In most states, insurance agents and brokers must meet certain standards to help ensure annuities are suitable for a client. They’re required to disclose their role, compensation and any conflicts of interest. They must also document in writing any annuity recommendation — along with their justification for the recommendation.

Additionally, insurers and agents are required to make a reasonable effort to gather information about your financial situation, investment goals and other pertinent details. If they don’t, and you feel pressured to make a decision quickly, that’s a red flag.

If an annuity doesn’t feel right, don’t hesitate to explore other options, says Daniel Milks, a certified financial planner and founder of Woodmark Wealth Management.

“Buyers should consider whether they’re better off with other investments or accounts, like IRAs or brokerage accounts, which might offer greater flexibility and lower fees,” says Milks.

Having second thoughts about your annuity? You can take advantage of the free-look period — a short window of time (usually less than 14 days in most states) to cancel your contract without penalty. During this time, you can review the terms and if you decide it’s not the right fit, you can return the annuity contract and get a full refund.

3. Does the annuity include a death benefit?

Some annuities include a death benefit so your beneficiary will receive the annuity’s value if you pass away before income payments begin. In some cases, the death benefit equals the total premiums paid.

Certain variable annuities offer an “enhanced death benefit,” locking in the highest value your account reaches during the contract.

“But these features often come at an additional cost,” says Milks. “If leaving a legacy is important, you need to understand exactly what’s included and whether it justifies the added expense.”

When a death benefit is available, beneficiaries typically have flexibility in how they receive the payout, such as a lump sum or periodic payments. Some contracts also allow your spouse to take over ownership of the annuity and continue receiving benefits.

4. What’s my annuity return based on?

Annuity payouts are influenced by numerous factors, but they generally measure their rate of return in one of three ways.

• Tied to an interest rate: fixed annuities and immediate annuities.
• Tied to a stock market index, such as the S&P 500: fixed-index annuities and registered index-linked annuities.
• Tied to the performance of underlying investments: variable annuities.

Here’s what to look for when an agent explains how your annuity’s rate of return is determined.

Fixed

Most fixed annuity contracts include both a minimum guaranteed interest rate and a current interest rate.

The current interest rate is almost always higher, and it’s usually the rate insurers advertise to attract new customers. For example, an annuity might have a current or initial rate of 6 percent and a guaranteed rate of 2.5 percent.

However, this current rate can fluctuate. In the first year, you might earn 6 percent, as a teaser rate. But it might not continue after that. Some companies try to maintain similar rates in future years, depending on investment performance and costs, while others only advertise the higher first-year rate as a temporary incentive.

To avoid surprises, ask about the current interest rate for annuities in their second or later years. This way, you can understand whether the initial rate is ongoing or only a first-year bonus, which can give you a clearer picture of what you can actually expect to earn long term.

Variable

When you invest in a variable annuity, your earnings are tied to the performance of investment options you select within the annuity’s sub-accounts. These can include stock, bond and money market mutual funds.

Some variable annuities also let you park your money in a fixed account with a guaranteed minimum interest rate. But keep in mind, variable annuities generally don’t guarantee your principal or promise any specific returns on your investments.

When you buy a variable annuity, the insurance company will provide a prospectus — a document that breaks down the annuity and its investment options. Review it carefully, and don’t hesitate to ask questions about anything you don’t understand.

Index linked

Two types of annuities connect your returns to a stock market benchmark, such as the S&P 500: fixed-index annuities (FIAs) and registered index-linked annuities (RILAs).

FIAs guarantee you won’t lose your initial investment, even if the market tanks. The catch? Your gains are capped, so when the market is booming, you’ll only share in the profits up to a certain point. So while you won’t lose your principal, your growth is stunted during strong market years, and you’ll never fully capture the gains of a bull market.

Meanwhile, RILAs work similarly to FIAs but come with more risk — and potentially more upside. Instead of fully protecting your principal, RILAs expose you to some market losses in exchange for greater participation in market gains.

If you’re considering an index-linked annuity, make sure you understand what index your returns are tied to. Some insurance companies now offer “hybrid indexes” that blend multiple indexes with cash or bond components.

While these hybrids may seem attractive on paper, many lack any real performance history. They’re designed to smooth out market volatility, but they often perform far below the S&P 500.

5. What charges and fees might be subtracted from the annuity’s value?

Fees can significantly eat away the value of your annuity. You need to know what you’re paying for and whether the benefits justify the costs.

Annuity fee structures can be complex. Fixed and fixed-index annuities might not have up-front charges, but commissions are often built into the policy. Simpler contracts with fewer features tend to have lower commissions, while more complex annuities or those with longer surrender periods often carry higher commissions.

Meanwhile, variable annuities have a range of fees, including mortality and expense charges, sub-account fees, annual contract fees, sales loads and surrender charges. These fees may be hidden in the fine print.

Optional features such as riders (i.e. guaranteed income or enhanced death benefits) also come with additional costs. These fees are typically deducted from your account value, reducing your overall returns.

Understanding how and when fees are applied is crucial. Always review charges carefully and consider how they impact your ability to accumulate wealth over time.

Bottom line

Annuities can provide financial security and steady income, but they’re complex products with lots of fine print. That’s why it’s so important to ask the right questions about fees, returns and withdrawal limits. Understanding how your annuity works — and the trade-offs involved — will help you make the right decision for your financial future.