It may not be good to have all your eggs in an annuity basket. Or even a majority of your eggs, financially speaking. These private income contracts do have potential flaws.
Fundamentally, an annuity contract means handing over your money to an insurer. In turn, the insurer pays out an income stream to you from that lump sum (or from the years of purchase payments you have made). The insurance company holds the money; you do not. From one standpoint, this arrangement has some merit; it relieves you of the burden of having to manage that money. From another standpoint, it has a few significant drawbacks.
Annuities are often illiquid. If you run into a situation where you need cash in retirement (a major home repair, a legal settlement, big medical expenses), do not expect to withdraw that cash from your annuity. If you have owned the annuity for some time, you may have to pay a hefty withdrawal penalty to access the money. From the insurer’s point of view, you are violating a contract. Should you have buyer’s remorse and decide you want out of your annuity contract soon after its inception, you will probably face a surrender charge. If you back out after the initial year of the contract, the surrender charge is commonly about 7% of your account value; it usually declines by a percentage point for each subsequent year you have spent in the annuity contract before surrendering.
Annuities come with high annual fees. A yearly management fee of 1.25% or more is not uncommon. Then there are mortality and expense (M&E) fees, fees for add-ons and guarantees, and up-front charges. If you have a variable annuity, throw in investment management fees as well. The “fee drag” for variable annuities may effectively eat away at their annual returns.
Annuity joint-and-survivor income provisions may not be as beneficial as they seem. Many annuities feature this payment structure, whereby the income payments continue to a surviving spouse after the death of one spouse. The downside of this arrangement: from the start, the income payments are less than what they ordinarily would be. If you are the annuity holder and you think your spouse may pass away before you do or are already confident that your spouse will be in a good financial position after your death, then a joint-and-survivor annuity payment structure may be nice, but not really necessary.
If you do not yet own an annuity, consider that you may not need one. The federal government basically gives you the equivalent of a deferred annuity: Social Security. Like an annuity, Social Security provides you with a reliable income stream – and your Social Security income is adjusted for inflation.
Think of an annuity as one potential piece of a retirement strategy. See it as a component or a supplement of that strategy, not the core.