Common Drawbacks and Costs to Understand Before Buying an Annuity

What makes annuities risky or expensive for some people

Annuities lock your money into a contract with an insurance company in exchange for regular payments. The main pitfalls are not that annuities are bad products — they work well for specific situations — but that they carry high costs, restrict your access to your own money, and can be sold in ways that don't match what you actually need.

The biggest complaint is that annuities are expensive. You pay surrender charges if you withdraw money early, often 5 to 10 percent of what you take out. You pay commissions to the person who sold it to you, usually 5 to 7 percent of your purchase price, though you don't see this line item — it comes out of the money the insurance company invests. You pay annual fees for management and insurance riders. Over time, these costs can eat into the returns you would have made in a regular investment account.

The second major pitfall is loss of control. Once you buy an annuity, your money is not yours to access freely. If you need cash for an emergency, you face a penalty. If you change your mind about the contract, you cannot straightforward sell it back — you are locked in for years. This matters most if your financial situation might change or if you are not certain you want to commit that money for decades.

Key Takeaways

• Annuities charge surrender fees (typically 5 to 10 percent) if you withdraw money before the contract term ends, which can last 5 to 15 years.
• Sales commissions and annual management fees reduce your actual returns, and these costs are often not clearly shown to you upfront.
• Once you buy an annuity, you lose the flexibility to access your money or change your mind without significant penalties.
• Some annuities are sold to people who do not need them or who could meet their goals more cheaply through other investments.
• Variable annuities tie your payments to stock market performance, which means your income can fluctuate and you bear the investment risk.

Surrender charges and early withdrawal penalties

A surrender charge is a penalty the insurance company charges if you withdraw more than a small amount of your money before the contract period ends. The charge is usually a percentage of what you withdraw, starting high in year one and declining each year. A typical schedule might be 10 percent in year one, 9 percent in year two, down to zero by year ten.

This means if you buy a $100,000 annuity and need $20,000 in year three, you might owe a 7 percent surrender charge on that withdrawal — $1,400 gone. If you need all your money back in year two, you could lose $9,000 to the penalty alone. The insurance company allows you a small withdrawal each year (often 10 percent of your account value) without penalty, but anything beyond that triggers the charge.

The surrender period varies by contract. Some last 5 years, others 10, 15, or even longer. Longer periods usually mean lower fees elsewhere in the contract, but they also mean you are locked in for a longer time. Before you buy, ask exactly what the surrender charge schedule is and how long it lasts.

Hidden fees that reduce your returns

Annuities often have multiple layers of fees that are not always obvious when you sign. The sales commission — typically 5 to 7 percent of your purchase price — is paid to the broker or agent who sold it to you. You do not write a separate check for this; the insurance company deducts it from the money they invest on your behalf. This means less of your money is actually working for you from day one.

On top of the commission, you pay annual fees. These might include a mortality and expense fee (the cost of the insurance company's may provide), administrative fees, and investment management fees if your annuity is variable. These fees are often stated as a percentage of your account value per year — sometimes 1 to 3 percent or more. Over 20 or 30 years, a 2 percent annual fee compounds into a significant reduction in what you receive.

If you add optional features called riders — such as a may provide that your payments will never drop, or a death benefit for your heirs — you pay extra for each one. These riders can add 0.5 to 1.5 percent per year to your costs. Many people buy riders they do not need because the salesperson presented them as protection, when in fact a simpler annuity would have served them better.

Complexity and sales pressure

Annuities are complicated products, and that complexity is sometimes used to your disadvantage. A salesperson might emphasize the may provide income or the death benefit while downplaying the fees, surrender charges, and restrictions. You might not fully understand what you are buying until after you have signed.

Sales commissions create a conflict of interest. The broker earns more money if they sell you a more expensive annuity with more riders and longer surrender periods. They have no legal duty to recommend what is best for you — only to recommend something that is not unsuitable. This is a much lower bar. You might be sold an annuity when a simpler investment would work better, or sold features you do not need.

Some annuities are marketed with language that sounds like a may provide but is not. For example, "principal protection" sounds like your money is safe, but it usually means only that you will not lose your initial investment — you might still lose money to fees and inflation. Read the actual contract, not just the marketing materials.

Inflation and fixed payment risk

If you buy a fixed annuity, your monthly payment stays the same for life. This sounds good until inflation arrives. If you lock in $2,000 per month at age 65, that $2,000 will buy much less at age 85. Over 20 years, inflation can cut the real value of your payment in half.

Some annuities offer a cost-of-living adjustment (COLA) rider that increases your payment each year to keep up with inflation. This is valuable, but it costs extra — usually 0.5 to 1 percent per year — and it reduces your starting payment. You have to decide upfront whether you want this protection. If you do not buy it and inflation rises faster than expected, you cannot add it later.

This is a particular risk if you are young when you buy the annuity or if you expect to live a long time. The longer you receive payments, the more inflation erodes their value.

Variable annuities and market risk

A variable annuity ties your payments to the performance of investments you choose — usually mutual funds. If the stock market does well, your payment might increase. If the market drops, your payment can fall. This means you bear the investment risk, not the insurance company.

Variable annuities are more expensive than fixed annuities because you are paying for investment management and the insurance company's may provide that your payment will not drop below a certain floor. These guarantees cost money — often 1 to 3 percent per year in fees. You are paying for protection you might not need if you are comfortable with market fluctuations.

If you want market exposure, you might be better off buying stocks or mutual funds directly through a brokerage account. You would pay lower fees, have more control, and could access your money without surrender charges. A variable annuity makes sense only if you specifically want the insurance company's may provide that your income will not drop below a floor, and you are willing to pay for that may provide.

Liquidity problems and opportunity cost

Once your money is in an annuity, it is not liquid. You cannot easily sell it or move it if you find a better investment or if your circumstances change. If interest rates rise and new annuities offer better terms, you are stuck with your old contract. If you need a large sum for a medical emergency or to help a family member, you face a surrender charge to get it.

This illiquidity has an opportunity cost. Money in an annuity cannot be used for other purposes. If you later wish you had kept some money in a regular savings account or investment account, you cannot go back in time. You have to weigh whether the may provide income from an annuity is worth giving up the flexibility of keeping your money accessible.

This is especially important if you are not yet retired or if your financial situation is uncertain. If you might need the money in the next 10 years, an annuity with a long surrender period is probably not right for you.

Who annuities are oversold to

Annuities are often sold to people who do not need them. A retiree with a pension and Social Security might not need additional may provide income, but a salesperson might convince them that an annuity is a safe place to park money. A younger person might be sold an annuity as a retirement savings vehicle when a regular 401(k) or IRA would be simpler and cheaper.

Annuities are also oversold to people who cannot afford the surrender charges. If you have limited savings and might need access to your money, locking it into an annuity is risky. If you face a health crisis or job loss, the surrender charge could force you to take a large financial hit.

Before you buy an annuity, ask yourself: Do I need may provide income? Will I definitely not need this money for 10 or 15 years? Am I comfortable with the fees? Could I meet my goals more cheaply another way? If you cannot answer yes to all of these, an annuity might not be the right choice.

Frequently Asked Questions

Can I get my money back from an annuity if I change my mind?

Most states have a free-look period of 10 to 30 days after you buy an annuity, during which you can return it and get your money back with no penalty. After that period ends, you can withdraw money, but you will owe a surrender charge. The charge declines each year and eventually goes away, but it can be substantial in the early years.

Are annuities FDIC insured?

No. Annuities are issued by insurance companies, not banks, so they are not covered by FDIC insurance. They are backed by the insurance company's financial strength and by state insurance guaranty funds, which protect you if the company fails. But this protection is limited and varies by state — it typically covers up to $250,000 per person per company.

What is the difference between an annuity and a CD?

A CD (certificate of deposit) is issued by a bank, is FDIC insured, and has no surrender charges — you can access your money after the term ends with no penalty. An annuity is issued by an insurance company, offers higher potential returns, but locks your money in with surrender charges and higher fees. CDs are simpler and safer; annuities offer more income but less flexibility.

Should I buy an annuity if I have a pension?

Probably not. If you already have a pension and Social Security, you already have may provide income. An annuity would add another layer of may provide income, which might be more than you need. The fees and surrender charges make it hard to justify unless you have a specific reason — such as a large lump sum you want to convert to income and no other way to do it.

Can I move money out of an annuity without a penalty?

You can move money to another annuity through a 1035 exchange, which is a tax-free transfer allowed by the IRS. However, you will start a new surrender period with the new annuity, so you are not really escaping the lock-in. You can also withdraw up to 10 percent of your account value per year in most contracts without a surrender charge, but anything beyond that triggers the penalty.