What Limitations Are There to an Annuity?

Annuities can be a safe way to grow your money – but they’re not without their limitations.

In our “Annuities – Why Ever Use Them” series, we’ve talked a lot about the advantages of using a fixed index annuity. However, there are always drawbacks. So, what do you need to be aware of?

If you’re thinking about purchasing an annuity, there are two main limitations to consider. The first is how liquid your annuity is, and the second is surrender charges. In this post, we’re going to explain how both of these limitations work, how to avoid them, and what you can do to balance your portfolio.

You can watch the video on this topic at the top of this post, to listen to the podcast episode, hit play below, or read on for more…

Annuities: the need-to-knows

Here’s a quick review of what we’ve covered about annuities in our series so far:

• There are two different types of annuities, deferred and immediate. Immediate annuities can provide you with income from the moment you set them up, whereas deferred puts your money aside to grow. In this series, we’re talking exclusively about deferred annuities.
• Deferred annuities can be either variable (where you invest in mutual funds, so there is risk involved) or fixed (principal guaranteed with no risk). Our focus is on fixed annuities.
• You can get a traditional fixed annuity, similar to a CD, where the insurance company gives you a fixed rate for a set number of years.
• Or you can get a fixed index annuity. Here, your interest is linked to the performance of an index, such as the S&P 500.
• A fixed index annuity earns interest through a cap or a participation rate.
• If you use a cap, and set it at 5%, for example, then if your index increases to 10% over an annual point-to-point reset, your annuity will increase by your cap amount of 5%.
• If you use a participation strategy and set it at 50%, then, if your index increases by 20% over the reset period, your annuity will increase by 50% of the index’s 20% growth (so, 10%).
• There are three reasons why people choose a fixed index annuity: safe accumulation, guaranteed income, and death benefit.

We’ve explained these points in greater depth in previous episodes of our “Annuities – Why Ever Use Them” series. To find out more about any of the points above, read the posts on our blog, listen to the episodes on the Secure Your Retirement podcast, or watch them on our YouTube channel.

How liquid is an annuity?

When an annuity is part of your portfolio, you need to know how accessible your money is. An annuity should never be the be-all and end-all of your portfolio. It should be one part that’s helping your money grow safely and securely, while other parts give you access to your money if you need it.

Annuities are not entirely restrictive. Most annuities allow you a penalty-free withdrawal. For the majority of annuities we recommend, this is usually between 7-10%, but it can vary. So, if you have $100,000 in an annuity, up to 10% of that ($10,000) is easily accessible to you.

But if 10% of your annuity isn’t enough to cover you in an emergency or you need frequent access to more liquid funds, what are your options?

We never suggest that you put all of your savings into an annuity because of their limited liquidity. Having unrestricted access to a fair amount of funds is paramount in retirement, so instead, we suggest splitting your money as part of a wider strategy. You could put 50% of your savings into an annuity, and the other 50% into stocks, bonds, ETFs, mutual funds, or another completely liquid asset.

So, if you have $1 million of savings and split it equally between an annuity and a fully liquid asset, you could have $550,000 of easily accessible cash. This equates to your $500,000 as a liquid investment and 10% available from your annuity.

How surrender charges affect your annuity

If you need more money than your penalty-free withdrawal amount allows, you may be subjected to a surrender charge. This is a period where you will have to pay a penalty to withdraw more than your limit. Let’s use an example to demonstrate.

Say you have $100,000 in your annuity, with a free withdrawal amount of 10% (so, $10,000), but you need access to $11,000. The 10% that you withdraw will be penalty-free, but that extra $1,000 will be subject to the surrender charge.

Insurance companies use surrender charges because they’re giving your investment guaranteed protection against market volatility. This comes at a cost to them as, to do this, they have to make long-term investments of their own. If you need to withdraw more money than they’ve prepared for, they will incur penalties. In essence, a surrender charge is a way of passing this penalty to you.

Most annuities that we work with have a surrender charge schedule lasting anywhere between seven and twelve years. Typically, these charges decline over time until they no longer apply, but this means they will be much higher in the initial years. So, if your annuity has a 10-year surrender charge schedule, you might face a surrender charge of 12% in the first year, 8% in the seventh year, and 0% in the eleventh year – as you’ll be out of surrender.

Your overall portfolio must ensure you have enough liquid assets so that you don’t have to worry about accessing cash or these surrender charges impacting your finances. There are pros and cons to every investment and limitations to how they work. So, how can you build a balanced portfolio?

The three elements to investing

There are three main elements to any investment strategy, safety, liquidity, and growth. No investment can suitably provide you with all three, but most investments give you two. So, how can different investments satisfy each element?

• If you’re concerned about safety and liquidity, then a money market might be the right investment for you. Bear in mind that it will not give you substantial growth.

• If you want liquidity and growth, the stock market could be a suitable solution. It has lots of growth potential but isn’t going to give you safety because there’s also the chance that you could lose money.

• If you prefer growth and safety, we recommend fixed index annuities. As we’ve seen in this post, they have limited liquidity, so it would be wise to use an annuity alongside another type of investment in order to give you a better amount of liquidity.

Remember that every investment has its limitations. But by thinking about these three elements, you can decide what is most important to you. You should keep these elements in mind when picking your own investments or work with a financial advisor to build a portfolio that covers all three bases.

If you want more information about preparing your finances for the future or retirement, check out our complimentary video series, “4 Steps to Secure Your Retirement.” In just four short videos, we teach you the steps you need to take to secure your dream retirement. Get the free series here.