An annuity is a financial contract between you and an insurance company where you make either a lump-sum payment or series of payments in exchange for regular income payments that begin either immediately or at a future date. Think of it as creating your own personal pension plan, but with more flexibility and control over timing and payout options.
While annuities are often positioned as retirement products, they’re really risk transfer mechanisms. You’re essentially paying an insurance company to take on the longevity risk (outliving your money) and, depending on the type, the market risk of your investments.
Types of Annuities
The annuity landscape splits along two main dimensions: when payments begin and how your money is invested.
Payment timing
| Type | Payment Start | Best For |
| Immediate annuity | Within one year of purchase | Retirees needing income now |
| Deferred annuity | Years or decades later | Accumulation phase investors |
Investment approach
Fixed annuities guarantee a specific interest rate and predictable payments. Your principal is protected, but your purchasing power may erode over time due to inflation. These work well for conservative investors who prioritize certainty over growth potential.
Variable annuities let you invest in sub-accounts similar to mutual funds. Your payments fluctuate based on investment performance, meaning you could receive more or less than expected. The trade-off: potential for higher returns but also the risk of losses.
Indexed annuities split the difference by linking returns to a market index (like the S&P 500) while providing downside protection. You typically get a percentage of the index’s gains with a floor that prevents losses during market downturns.
Strategic Considerations
The insurance company is betting against you. They’ve run the actuarial tables and priced the annuity assuming most people won’t live long enough to get back more than they paid in. This isn’t inherently bad, but it means annuities work best for people with longevity in their family history.
Liquidity matters more than you think. Most annuities lock up your money with surrender charges that can last 7-10 years. Emergency funds and other liquid assets become even more critical when a significant portion of your wealth is tied up in an annuity contract.
Tax treatment creates both opportunities and traps. Money grows tax-deferred inside the annuity, but all withdrawals are taxed as ordinary income, not capital gains. This makes annuities less tax-efficient than other investment vehicles for people in high tax brackets.
Payout Options and Their Implications
When you annuitize (convert your account value to income payments), you’ll choose from several payout structures:
Life only provides the highest monthly payment but stops completely when you die, even if that’s one month after payments begin. Your heirs get nothing.
Life with period certain reduces your monthly payment but guarantees payments for a specific period (usually 10-20 years) even if you die early. Any remaining payments go to your beneficiaries.
Joint and survivor covers two people (typically spouses) and continues payments as long as either person is alive. Payments are lower than single-life options but provide security for the surviving spouse.
The irrevocability problem: Once you choose your payout option and begin receiving payments, you typically can’t change your mind or access your principal. This differs from systematic withdrawals from other retirement accounts, where you maintain control over your assets.
When Annuities Make Strategic Sense
Annuities work best as income flooring rather than wealth accumulation tools. If you’ve maximized other tax-advantaged accounts and need guaranteed income to cover essential expenses in retirement, an immediate annuity can provide peace of mind that market volatility won’t affect your basic living standards.
They also make sense for people who lack the discipline or desire to manage withdrawal rates from their retirement accounts. The “behavioral insurance” aspect of guaranteed payments can be worth the fees for some investors.
Consider annuities when:
- You’ve exhausted other tax-advantaged retirement accounts
- You need guaranteed income to cover fixed expenses
- You have family history of longevity
- You want to transfer longevity risk to an insurance company
- You lack confidence in managing retirement withdrawals
Avoid annuities when:
- You need liquidity and flexibility
- You’re in high tax brackets and prioritize tax efficiency
- You have shorter life expectancy
- You want to maximize legacy wealth for heirs
- You’re comfortable managing investment and withdrawal risks yourself
Frequently Asked Questions
State guarantee associations protect annuity holders up to certain limits (typically $250,000-$300,000 depending on your state). This provides some protection, but buying from highly-rated insurers remains important for larger annuity purchases.
Most annuities allow annual withdrawals of 10% without surrender charges after the first year. Beyond that, you’ll pay surrender charges plus potential IRS penalties if you’re under 59½. Some contracts offer penalty-free withdrawals for nursing home care or terminal illness.
Fixed annuities typically have no explicit annual fees, with costs built into the interest rate offered. Variable annuities can charge 1-3% annually in management fees, insurance charges, and rider costs. Index annuities fall somewhere between, often with caps or participation rates that limit your upside in exchange for downside protection.
This rarely makes sense since IRAs already provide tax deferral. You’d be paying for a tax benefit you already have while adding fees and reducing liquidity. Direct annuity purchases with after-tax money typically provide better value.
