Annuities and the elderly — what they are and when they make sense
This article is for educational purposes only and does not constitute medical, legal, or financial advice. Every family situation is different, and you should consult with appropriate professionals about your specific circumstances.
Your parent mentions that someone called about an annuity, or a relative suggests your parent buy one to generate income. You look it up online and find articles warning about annuities being a terrible rip-off, alongside other articles promising lifetime income security. So which is it? Is an annuity a clever financial tool or a trap?
The confusion around annuities is real. Annuities have features that are genuinely useful for some older people and features that genuinely hurt others. The difference isn't the annuity itself. It's whether the specific annuity matches your parent's actual needs and circumstances. A powerful financial tool in the wrong situation becomes a bad decision that's hard to undo.
When you're helping your parent manage money, understanding annuities matters because they're sold directly to older adults, they're complicated enough to confuse most people, and they involve decisions that lock up money for years. If your parent is considering buying one, or if they already own one that you're discovering now, you need to understand what it actually is and what it actually costs.
An annuity is a contract between your parent and an insurance company. Your parent gives the insurance company a lump sum of money right now, and the insurance company promises to give your parent money back over time. The pattern might be monthly payments for life, or a certain number of years, or something else entirely. What makes annuities different from just keeping money in a savings account is that an insurance company is making a promise about what will happen in the future, and they're taking a risk by doing that.
Understanding the Basics
There are several basic types of annuities, and the names matter because they mean different things. The simplest is a fixed annuity. Your parent gives the insurance company money, and the insurance company pays them a guaranteed monthly amount for a set period or for life. That guarantee is what makes it "fixed." Your parent knows exactly what the payment will be. It doesn't go up if the market goes up. It doesn't go down if the market goes down. This appeals to people who want predictability and can't stand the thought of their income varying month to month.
A variable annuity is different. Your parent's payment amount is tied to how investments perform. If the stock market does well, the payment might increase. If it does poorly, the payment might decrease. Variable annuities come with investment options, kind of like a 401(k). Your parent can choose how their money is invested among different fund choices. The risk here is different too. Instead of the insurance company promising you a fixed amount, they promise that your money will be managed according to your instructions. But the payment amount depends on investment performance, so there's no guarantee.
An indexed annuity is a middle ground. Your parent's payment is tied to a market index, like the S&P 500, but there are limits. Usually there's a floor, meaning the payment won't go below a certain amount even if the market crashes. There's also often a cap, meaning the payment won't go above a certain amount even if the market soars. The insurance company is betting they can make money by taking the upside they capture above what they pay you, while you get the benefit of some market growth protected by a floor.
The most common reason someone buys an annuity is to get income they can't outlive. If your parent lives to 95 and their savings would have run out at 88, an annuity that pays for life solves that problem. The insurance company is betting on life expectancy tables. If your parent lives exactly to the average age, the insurance company breaks even. If they live longer, the insurance company loses money on that contract. If they live shorter, the insurance company profits. The insurance company makes money overall by managing thousands of annuities and betting on the statistics. Your parent makes money if they live longer than average.
For some older adults, this is genuinely attractive. If your parent is healthy with a long family history of longevity, if they're terrified of running out of money in their 90s, and if they have enough money now but not guaranteed income, an annuity that pays $2,000 a month for life might feel like security. And it is a real guarantee—the insurance company is legally obligated to pay, and that obligation is backed by insurance company reserves and state insurance regulation.
Where annuities cause problems is in the details and the costs. Most annuities come with surrender charges. If your parent gives an insurance company $200,000 and wants it back after five years, they might only get $170,000. The company keeps the other $30,000 as surrender charges. This is supposed to be the cost of their guarantee, but it's a significant cost that makes annuities illiquid. Your parent's money gets locked up, and getting it out early is expensive.
Many annuities also have annual fees. Some charge a percentage of the account balance annually, sometimes 1% to 2% or more. Over decades, those percentages add up. An annuity with a 1.5% annual fee will cost a lot more than a traditional investment account where you might pay 0.1% or less. These fees are supposed to pay for the insurance company's costs and profit, but they matter to your parent because that's money not growing and not available for spending.
Variable annuities come with additional complexity. They often have subaccount fees, meaning each of the investment options has its own expenses. They might have riders, which are add-on features you can purchase. A long-term care rider, for example, might let your parent access some of the annuity early if they need money for nursing home care. Riders sound good until you learn they cost extra and have limits on what they'll actually cover.
An indexed annuity's cap and floor are not free either. The insurance company is willing to give your parent a floor because they capture the benefit of market gains above the cap. If the market goes up 12% but your annuity only credits 8% because of the cap, the insurance company keeps the extra 4%. That's their profit for offering you the floor. Your parent is trading upside potential for downside protection.
Here's the thing that affects your parent's care situation: most annuities are not designed to be short-term decisions. They're designed to lock up money for years so the insurance company knows they can pay out the guaranteed amount. If your parent buys an annuity at 72 and ends up needing expensive care at 75, that money might not be accessible without paying surrender charges. If your parent's health changes and you realize you need liquid assets for healthcare, an annuity becomes a liability rather than an asset.
Some annuities have nursing home riders that waive the surrender charge if your parent needs long-term care. But these riders cost money when you buy them, and they have limits. Some let you access only 100% of the premium paid, not including any growth. Some let you access more, but only up to a maximum. Before your parent commits to an annuity, you need to understand exactly what happens to the money if care becomes necessary.
Your Parent's Specific Situation
Before your parent buys an annuity, several questions need answers. First, does your parent actually need an annuity? This is not a small question. Many people with enough savings, adequate Social Security, and a pension don't need an annuity. They don't need extra income because they already have enough. For them, buying an annuity means converting money that could go to heirs or be used flexibly into an insurance company obligation. That might still make sense if they're afraid of running out of money, but fear alone isn't a good reason.
What is your parent's life expectancy? This matters because annuities work best for people who live longer than average. If your parent has significant health issues and a life expectancy below average, an annuity is a bad deal. The insurance company designed it to make money on people who live average or shorter lives. People who live much longer get the benefit. If your parent is 85 with serious health conditions, you're probably not buying an annuity.
What is your parent's income situation right now? How much does Social Security provide? Does your parent have a pension? Are there other sources of guaranteed income? If your parent already has substantial guaranteed income, another annuity might be overkill. If your parent relies entirely on Social Security and has significant savings but no guaranteed income, an annuity that converts some of that savings to income might make sense.
How much liquid money does your parent have outside of retirement accounts? This is critical because you might not want all your parent's money in an annuity. Annuities are illiquid. If your parent has $300,000 in savings and puts it all in an annuity, they have no liquid emergency funds. If they have $300,000 and puts $100,000 in an annuity while keeping $200,000 liquid, that's much safer.
Who is selling this annuity, and what do they make on the sale? Many annuities come with high commissions to the salesperson. An annuity with a 7% commission means the salesperson makes $7,000 on a $100,000 sale. That salesperson is highly motivated to sell annuities, even if a different product would be better for your parent. If a salesperson is pushing hard, that's a red flag. Real advisors who are fiduciaries—legally required to put client interests first,are often less enthusiastic about annuities because the commissions are lower than they'd earn on other products.
Is this annuity purchased with retirement account money or regular money? Annuities purchased inside a 401(k) or IRA are already tax-deferred, so buying a tax-deferred annuity inside a tax-deferred account is redundant. You're paying for a feature you already have. Non-qualified annuities,purchased with regular after-tax money,are different. They offer tax deferral, which can be valuable if your parent is in a lower tax bracket now than later.
What happens if your parent changes their mind? Some annuities have surrender periods where your parent can change their mind without penalty only during the first 30 days. Others let you surrender anytime but charge you for it. A few have free look periods of 10 or 14 days where your parent can return the annuity no questions asked. If your parent isn't absolutely certain, they should insist on a free look period and think about it carefully.
Does this annuity have any features that apply to your parent's life? If your parent has no heirs and doesn't care what happens to the money after they die, a simple life annuity might be perfect. The insurance company can offer a lower payment because they keep anything left when your parent dies. But if your parent wants to leave money to heirs, they might need a joint and survivor annuity (which pays your parent and then a survivor for life) or a period-certain option (which guarantees payments for a certain number of years before switching to life). These options cost more because they limit the insurance company's upside.
Taking Next Steps
If your parent is considering an annuity, slow down. Don't make this decision in a week. Don't make it based on a phone call from a salesperson. Don't make it because someone says it's the best investment. Here's a reasonable approach.
First, get a second opinion from someone who doesn't earn commission on selling annuities. This might be a fee-only financial planner, a certified financial planner, or even your parent's CPA. Show them the specific annuity contract and ask whether it makes sense for your parent's situation. Ask them what they'd recommend instead. Listen to what they say. If they strongly advise against it, ask them why. Good advisors can explain their reasoning clearly.
If your parent decides an annuity does make sense, insist on reading the full contract. The glossy sales brochure is not the contract. The contract is long and dense and explains everything including surrender charges, fees, riders, and conditions. Have your parent read it with an advisor or attorney who can translate it into English. If anything doesn't make sense or feels hidden, it probably is.
Ask the insurance company for a detailed illustration of what your parent will receive. A good illustration shows what happens year by year, what fees get deducted, what the account balance will look like, and what income your parent gets. Ask specifically what happens if your parent needs the money for care, or becomes disabled, or dies. Ask what happens if the insurance company's financial rating changes. Ask whether there are any limitations on withdrawals.
Confirm the insurance company's financial strength. Insurance companies sometimes fail, which affects whether they can pay the annuities they've promised. Check ratings from AM Best, which rates insurance company financial strength. A company with a B+ or higher rating is generally safe. A company with a lower rating is riskier.
If your parent has already bought an annuity that they now regret, there might be options. Some annuities can be exchanged for other products tax-free under section 1035 of the tax code. Some have free look periods that are still active. Some have been sold with issues that make them candidates for complaint to the state insurance commissioner. If your parent feels they were sold something inappropriate, it's worth asking a securities attorney whether there are grounds to challenge the sale.
If your parent already owns an annuity and you're just discovering it, track down the contract and understand what it is. Get the current surrender value. Understand the fees. Know what your parent is getting paid and what it costs them. Some old annuities are good, and some are problematic. Some have features that made sense when bought but don't make sense anymore. Knowing what you have is the first step to deciding what to do.
Annuities are not inherently bad financial products. For the right person in the right situation with the right contract, they provide valuable security. The risk isn't the annuity. The risk is buying one without understanding it, or buying one because a salesperson convinced you to, or buying one without a clear reason for why you need it. Your parent worked hard to build that money. Making sure it goes to their actual needs instead of an insurance company's profit margin is the only sensible approach.
How To Help Your Elders is an educational resource. We do not provide medical, legal, or financial advice. The information in this article is general in nature and may not apply to your specific situation. If you are concerned about a loved one's cognitive health or safety, consult with their healthcare provider or contact your local Area Agency on Aging for guidance and support.