An annuity is a contract you buy from an insurance company. You give the company a lump sum of money, and in return, they promise to pay you income for a set period of time, or for the rest of your life. Annuities are primarily used for retirement income. They solve a specific problem: making sure you do not outlive your money.
How Annuities Work
When you buy an annuity, you enter a contract with an insurance company. You pay a premium, either a single lump sum or a series of payments. In the accumulation phase, your money grows inside the contract. In the distribution phase, the insurance company pays you income according to the terms you selected.
The income can be structured many ways: a fixed amount for a set number of years, a fixed amount for life, or a variable amount tied to investment performance. The terms you choose at purchase determine your payment amounts and how long they last.
Types of Annuities
Fixed Annuity
A fixed annuity pays a guaranteed interest rate during the accumulation phase. The rate is set for a specific period, similar to a CD. When you annuitize (convert to income), you receive predictable, fixed payments. Fixed annuities are low risk and easy to understand. The downside is that the guaranteed rate may not keep up with inflation.
Variable Annuity
A variable annuity lets you invest your premium in subaccounts that function like mutual funds. Your account value goes up and down with the market. When you annuitize, payments vary based on account performance. Variable annuities carry investment risk but offer the possibility of higher returns. They also carry higher fees than fixed annuities.
Indexed Annuity (Fixed Indexed Annuity)
An indexed annuity ties your interest to the performance of a stock market index, such as the S&P 500, but with a floor (usually 0 percent) that protects you from losses. If the index goes up, you earn interest up to a cap. If the index goes down, you earn 0 percent rather than losing money. This is a middle ground between fixed and variable.
Immediate Annuity
You pay a lump sum and income payments start within one month. Immediate annuities are common for retirees who want to convert savings into a guaranteed income stream right away. They are simple: give the insurance company money, get monthly checks for life (or for a fixed period).
Deferred Annuity
You pay into the annuity now but do not start receiving income until a future date. This gives the money time to grow. Deferred annuities can be fixed, variable, or indexed. They are used for accumulation over many years before retirement begins.
Annuity Payment Options
When you start receiving income, you choose a payout structure:
- Life only: Payments continue for as long as you live. Once you die, payments stop. This maximizes your monthly income but leaves nothing for heirs.
- Life with period certain: Payments continue for life, but if you die before a specified period (10 or 20 years), payments continue to your beneficiary for the rest of that period.
- Joint and survivor: Covers two people, typically spouses. Payments continue as long as either person is alive, usually at a reduced amount after the first person dies.
- Fixed period: Payments last for a set number of years, such as 20 years, regardless of whether you are alive. If you die early, your beneficiary receives the remaining payments.
Pros of Annuities
- Guaranteed income for life: You cannot outlive a lifetime annuity. This solves the biggest risk in retirement planning.
- Tax-deferred growth: Money inside an annuity grows without being taxed until you take withdrawals.
- No contribution limits: Unlike IRAs or 401(k)s, there is no annual limit on how much you can put into a non-qualified annuity.
- Principal protection (fixed and indexed): Your original investment is protected from market losses in fixed and indexed annuities.
Cons of Annuities
- High fees: Variable annuities in particular can have annual fees of 2 to 3 percent or more, including mortality and expense charges, administrative fees, and fund fees. These fees compound and significantly reduce your returns over time.
- Surrender charges: If you withdraw money before a specified period (often 7 to 10 years), you pay a surrender charge of up to 10 percent. Your money is locked up.
- Complexity: Annuity contracts are long and filled with terms that benefit the insurance company. The features and riders are difficult to evaluate without help.
- Inflation risk (fixed annuities): A fixed monthly payment worth $2,000 today will buy less in 20 years due to inflation.
- Commissions: Annuities are heavily sold by financial advisors who earn large commissions. This creates a conflict of interest.
When an Annuity Makes Sense
Annuities are most useful in specific situations:
- You have already maxed out your 401(k) and IRA and want another tax-deferred account.
- You are worried about outliving your savings and Social Security alone does not cover your basic expenses.
- You want a simple, guaranteed monthly check in retirement without managing investments.
- You have a pension gap — your basic living costs exceed your guaranteed income sources.
When an Annuity Does Not Make Sense
- You have not maxed out your 401(k) and Roth IRA first. Those offer better terms and lower costs.
- You are young and decades from retirement. The fees erode returns significantly over long periods.
- You need liquidity. Surrender charges make it expensive to access your money early.
- You are buying based on a salesperson’s pitch rather than a specific need. Most people are oversold annuities.
How to Evaluate an Annuity
If you are seriously considering an annuity, compare at least three products. Look at the total cost (all fees combined), the surrender charge schedule, the financial strength rating of the insurance company (A or better from AM Best), and the guaranteed payout rate. Working with a fee-only financial advisor who does not earn commissions is the safest way to evaluate whether an annuity fits your plan.