What you must understand before buying an annuity

Annuities were initially created to protect people in old age by providing an income that they could not outlive. Insurance companies would write contracts offering to pay the buyers income for life. Thanks to the law of large numbers, if a person lived longer than expected, the funds of someone who died earlier than expected could be used to pay the additional funds. This original purpose of an annuity is a good and noble one, but along the way things changed.

Annuities are not as liquid as you might think. If you make a withdrawal before age 59-1/2, there is a 10% IRS penalty, just like a retirement account. There may also be hefty surrender fees, if you have not owned it for many years. In addition taking a withdrawal will permanently reduce your income guarantee in most cases.

Most annuities pay income to the beneficiary for life. There is an insurance cost for this, and it will reduce your fund's ability to grow.

Once you begin taking annuity income, if your investments decline and your income is guaranteed never to decrease, you will begin eating into your principal at an increasingly rapid rate. Eventually there may be nothing left—even though you will still receive income.

Once you have the annuity, you will be restricted to the investments offered, good or bad. You may even be subject to inflexible portfolio restrictions, which may increasingly reduce your equity exposure and the likelihood of your income growing as you age.

Eventually most annuity owners end up living on fixed income. If inflation averages just 3% over the next 20 years, their monthly annuity check will buy little more than one-half of what it will today.

Fixed annuities are long-term investment vehicles designed for retirement purposes. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company.