Facts

An annuity is a contract between an insurance company and an individual. The individual pays one large payment or a series of payments to the insurance company. In exchange, the insurance company provides periodic payments, typically a stream of income during retirement. Payments can occur immediately or at a future date. Two types of annuities exist: fixed or variable. In a fixed annuity, the company guarantees an exact price does not fluctuate. A variable income's payout depends on the performance of underlying investment options.

Risks

The guarantee of an annuity is as strong as the financial strength of the insurance company that provides the annuity. Annuities are not insured by the FDIC. Therefore, if the insurance company flounders, how much the state covers, or how much they pay, depends on the individual state's laws and regulations.

Fees

Though annuities are known for their advantages, hidden fees can exist, so it is important to read the fine print. Since annuities are sold by insurance brokers, commission can be steep and can equate to as much as 10 percent of the annuity. Variable annuities can have high annual fees that can include an annual insurance charge for 1.25 percent or more; annual investment management fees that can range from 0.5 percent to above 2 percent; and fees for insurance riders that can add 0.6 percent or beyond.

Withdrawals

If you pull money out of an annuity before due time, a surrender charge can range from approximately 7 percent to 20 percent. Like an IRA or 401(k), it is not a good idea to withdraw money until 59 1/2, because withdrawals made prior can receive a withdrawal penalty of approximately 10 percent.

Sales

Fee structures can be complex and vague. Insurance agents may enhance positive features and downplay potential drawbacks. In her January 2007 Kiplinger article, Kimberly Lankford revealed that in 2005, the North American Securities Administrators Association, the group for state securities regulators, claimed that dishonest annuity sales practice was one of the top ten threats toward investors. The most looming problem may not be in the product itself, but the way the product is being sold. Beware of some insurance brokers or agents who withhold knowledge of investment risk, surrender charges and other fees.