As more than 10,000 baby boomers cross the retirement threshold each day, an increasing number of retirees and pre-retirees are turning to annuities for greater predictability and financial security. As investment vehicles, annuities are genuinely unique, offering several advantages – and disadvantages – over other types of investments. And, in the context of one’s financial plan, they can be a vital component of an overall investment portfolio adding stability, tax relief, asset protection, income security, and general peace-of-mind.

However, as with any type of investment, annuities are not for everyone. If you’re considering purchasing an annuity, here’s what you need to know.

Annuity Advantages

Taxed deferred accumulation: The earnings inside of an annuity are allowed to accumulate without paying current taxes, enabling them to grow faster. If your adjusted gross income places you in the upper-income tax brackets, you could benefit from a deferral of taxes on investment earnings. For example, if your combined federal and state income tax rate is 48 percent (i.e., 38 percent federal, 10 percent state), each dollar of investment earning not currently taxed, saves you 48 cents. When left to accumulate over time, those tax savings can accelerate the accumulation of funds. While you will eventually pay taxes on your earnings, you are likely to do so at a lower income tax rate in retirement. Even, if your tax rate is the same, you can control your withdrawals so that more is taken during years of lower taxation and vice versa.

Additionally, unlike qualified retirement plans, in which a Required Minimum Withdrawal provision applies when you reach age 70 ½, there is no such requirement with annuities so you can continue to defer taxes as long as you wish.

Competitive interest rates: Fixed annuities pay a rate based on yields generated from a life insurance company’s own investment portfolio, which tend to be higher than equivalent savings or investment vehicles such as money market accounts or CDs.

Minimum rate guarantees: After the initial interest rate guarantee expires, it is adjusted to current market rates which could be higher or lower, but never lower than the minimum rate stated in the contract.

Safety of principal: In fixed annuities, the principal balance is backed by the assets of life insurance companies.  Because life insurers must meet stringent reserve requirements imposed by the states, the likelihood of a default is very minimal. The highest rated life insurers are deemed to be the safest of all financial institutions. Also, most states have a guaranty fund to cover any annuity losses.

Access to funds: Annuity contracts allow for an annual withdrawal of up to 10 percent of the account balance without any charge. After the surrender period, which can last as long as 12 to 15 years, contract holders can have access to 100 percent of their money.

Guaranteed lifetime income: The one investment objective annuities can achieve that no other vehicle can is to provide a guaranteed stream of income that a person cannot outlive.

Reduced Social Security Taxation: Generally, Social Security benefits are received tax-free. But, if your total income from all sources crosses a certain threshold ($32,000 for joint filers), a portion of your benefits, up to 85 percent, can become taxable. Included in the social security tax calculation is interest earned from tax-exempt bonds. Annuity income is exempt from the calculation.

Asset protection: Annuities are one of the few investments that may be exempt from creditors or legal actions against your assets. Each state has established its own rules and limitations on annuity exemptions, so be sure to check with the rules of your particular state.

Probate Protection: As with life insurance proceeds, annuity proceeds pass outside of probate which can protect them from the delays and expenses associated with probate proceedings.

Annuity Disadvantages

Taxable Withdrawals: At some point, the IRS wants its share. Since annuity earning accumulates tax-deferred, they are taxed at the time of withdrawal as ordinary income. Depending on whether you are in a higher or lower tax bracket at the time, it could either be a disadvantage or advantage.

Penalty for early withdrawals: For the privilege of deferring taxes on earnings inside an annuity, the IRS will penalize any withdrawal made prior to age 59 ½.  An annuity can be converted to a stream of lifetime income at any time (referred to as “annuitization”) which means you can begin to receive periodic payments without incurring a penalty.

Surrender fees: While annuities allow for access to account balances, there is a charge if the withdrawal exceeds 10% of the balance in a year.  The fees start out relatively high (7% to 15%), but they decline by a percentage point each year until they vanish, which usually coincides with the end of the surrender period.

Fees and expenses: One of the criticisms leveled at annuities is that they are generally more expensive to buy and maintain as they have fees and costs not found in other types of investments. Fees are deducted from your account balance each year to cover mortality costs and administrative expenses. Most of the fees annuity holders pay are hidden and not easily understood by the annuity holder. Also, some annuity products are sold with a sales load or commission. Because the competition for annuity money is fierce, you can find “low cost” annuities with reduced surrender fees and no- or low-commissions.

The “Risks” of Owning an Annuity

While annuities are considered “low risk,” there are risks inherent in any savings or investment vehicle. Before purchasing an annuity, it would be important to consider all risks in the context of your financial plan.

Liquidity Risk

Except for the annual 10 percent withdrawal allowed in annuity contracts, annuities should not be considered liquid assets. While you do have complete access to your money in a deferred annuity, the fees and penalties you might pay for an early withdrawal could impact your principal amount. Once you convert a deferred annuity to an income annuity, you no longer have access to your money.

You shouldn’t consider purchasing an annuity if you don’t have sufficient liquid assets elsewhere in your portfolio.

Interest Rate Risk

Anytime you invest in a fixed-rate vehicle, you expose funds to interest rate risk. If you choose an annuity with a one-year rate guarantee and interest rates decline, you risk receiving a lower rate in future years. If you select an annuity with a multi-year guarantee and interest rates increase, you risk missing out on the higher rates in future years.

Credit Risk

Annuities are backed by the financial strength of the issuing life insurer. If an insurer does become insolvent, your funds could be at risk. While there have been cases of insurance company bankruptcies, they are very rare, especially when compared to banks. In fact, there have only been a few cases where annuity owners received less than what the insurer promised. That’s because insurance companies are much better capitalized than banks. Plus, annuity owners are protected by their state guaranty fund.

You can reduce credit risk by selecting annuities issued by life insurers carrying the highest credit ratings (A+ from Best, AAA from Moody’s or Standard & Poor’s).

Inflation Risk

Most “safe” investments can expose your funds to inflation risk. If the return on a fixed annuity or the payout of an immediate annuity does not keep pace with the rate of inflation, you risk the loss of purchasing power in the future. That shouldn’t be a concern if a portion of your investment portfolio is invested in equities, which are a proven hedge against inflation.

Generally, annuities are most appropriate for people with a long-term time horizon, who could benefit from tax-deferred growth on their funds, and who are mainly concerned with safety, stability and future financial security.  One way to evaluate annuities as a possible investment choice for your own situation is to consider their advantages, disadvantage, and risks in your particular situation. Because annuities can be complex and there are many different types, they should be considered with the guidance of an independent financial advisor with experience in annuities.