Annuities are often sold as the ultimate retirement solution. The pitch is simple: hand your money to an insurance company, receive guaranteed income, and stop worrying about market volatility.
On paper, it sounds appealing: But many investors don't realize that annuities introduce a different set of risks; risks that are often harder to understand than stock market fluctuations. Recent events involving troubled annuity issuers highlight an important reality: when you buy an annuity, you're not eliminating risk. You're simply exchanging one type of risk for another.
The Risk Nobody Talks About: Losing Access to Your Money
One of the biggest drawbacks of annuities is that they are fundamentally illiquid. When you invest in a stock, bond, ETF, or mutual fund, you can typically sell your investment and access your money whenever you want. The value may fluctuate, but the money is yours because you can easily turn your investment back into cash.
Annuities are different: Many annuities impose surrender charges that can last for years. Some limit how much you can withdraw annually without penalties while others make it extremely costly to exit the contract early.
This means that if your financial situation changes, you may discover that your retirement savings are effectively locked up. Liquidity matters more than most people realize because life is unpredictable: Medical expenses arise, family circumstances change, new investment opportunities appear. Having access to your own money has more value than people think when considering an investment. Once funds are committed to an annuity, that flexibility largely disappears.
You're Betting on an Insurance Company
Many investors think of annuities as "guaranteed." What they often overlook is a simple question: Guaranteed by whom?
Every annuity guarantee is only as strong as the insurance company making the promise. Unlike a Treasury bond, which is backed by the U.S. government, an annuity is backed by a private insurer. If that insurer experiences financial distress, the situation can become complicated very quickly.
A recent lawsuit against LPL Financial illustrates this risk. According to the complaint, an annuity issuer experienced years of financial deterioration before eventually being placed into rehabilitation by regulators. Policyholders allegedly found themselves facing restrictions on accessing their money, despite having purchased products marketed for retirement security. The details of that lawsuit will ultimately be decided in court. But the broader lesson is clear: annuity holders are exposed to issuer risk whether they realize it or not. When you buy an annuity, you are effectively making a long-term credit bet on a single insurance company.
Counterparty Risk Can Take Decades to Appear
The most dangerous risks are often the ones that remain invisible for years. An insurance company can appear healthy today and encounter serious problems years later. Their credit ratings can be downgraded while their capital positions deteriorates. Meanwhile, annuity owners may have little ability to exit the contract without significant penalties—or may not even be aware that the insurer's financial condition is worsening.
This creates a troubling combination:
- Your money is locked up.
- Your investment depends on a single issuer.
- Problems may not become apparent until years later.
Investors often spend enormous effort diversifying stocks and bonds while unknowingly concentrating a large portion of their retirement savings with a single insurance company.
Fees Make the Problem Worse
Many annuities also carry substantial costs. Depending on the product, investors may pay mortality and expense charges, administrative fees, rider fees, investment management fees, and commissions. These costs can significantly reduce long-term returns. High fees alone are a concern. But they become even more problematic when paired with limited liquidity. Investors may discover that they're paying ongoing fees for a product they can no longer easily leave.
The Better Question
When evaluating an investment, many people ask: What's the return?
A better question is: What could go wrong?
With annuities, the answer is often more complicated than investors expect, and often is hard to quantify: You can lose flexibility, you can become dependent on the financial health of a single insurer., you can pay substantial fees. And if trouble emerges years later, you may find that accessing your money is far more difficult than you imagined. That's why investors should be skeptical whenever a product promises certainty or guarantees.
In investing, risk can never be eliminated; it can only be shifted, which, overlaid with your own view and utility function, may result in a better outcome for you. Annuities likely won't help you: They simply replace market risk with liquidity risk, counterparty risk, and fee drag, risks that are often less visible, but will hurt you in the worst possible scenarios.
So what's the better solution?
Most annuities reference a set of stocks, bonds, or other publicly traded assets. The issuer of the annuity will typically hedge their exposure to those underlying assets by engaging a bank to provide a swap. Without going into the economics of that piece, the point is that the issuer eliminates the market risk and are, net, only selling their credit to you (i.e. you fund the insurance company). As an investor, you are likely only interested in the market risk to generate returns or yield. The better solution therefore is to do what the hedging bank does: allocate the correct amount to the individual, publicly traded securities and rebalance as needed. That way, you generate a similar payoff, have the liquidity of publicly traded securities, and eliminate counterparty risk to a single insurance company.