What Is an Annuity?

Annuities can be useful in retirement by giving you a predictable income stream. But there are also some real drawbacks.

Written by Devon Delfino / March 10, 2022

Quick Bites

  • An annuity can offer a source of steady income in retirement.
  • There are three types of annuities: fixed, variable and indexed.
  • Annuities can also be used to meet specific financial goals, like paying off a mortgage.
  • Along with the benefits, there are several important downsides to annuities.

Retirement planning is filled with decisions. Should you retire at 59½? Should you wait? Do you have the right retirement accounts to rely on? Will your savings be enough?

Annuities can be an option to help out with income stability in retirement. Here’s what you should know about them, including how they work, who they’re best for and potential drawbacks.

Inside this article

  1. What’s an annuity?
  2. How do annuities work?
  3. Types of annuities
  4. Are annuities right for you?
  5. Potential drawbacks to annuities

What’s an annuity?

An annuity is an insurance product that requires the insurer to make payments to you. Often, those are doled out over a specified period of time or starting at a predetermined point in the future. So, unlike life insurance, it’s about planning for your future, rather than protecting loved ones in the event of death (although depending on the type of annuity you choose, you could designate a beneficiary to receive benefits after you pass away).[1]

You can find annuities through insurance companies, as well as banks, mutual fund companies and brokerage firms.[1]

How do annuities work?

At a basic level, you hand over a certain amount of money to an insurance company. In exchange, the company invests that money and provides you with a steady stream of income at a predetermined time in the future. For example, you could choose to receive payments at a certain time (like when you reach retirement) and continue them until you die, for a 20-year period or until both you and your partner die. It all depends on the terms of the annuity.

Although you’re the one funding the annuity, that doesn’t mean you can access that money at any time without consequences.[1] And you might pay surrender charges for taking out money ahead of schedule, which typically lasts six to eight years from when you purchase the annuity.[2]

After the annuity is fully funded, or when the payments are set to begin, the insurer will start paying out. For example, if you were to pay $1,000 a month toward a fixed annuity (more on that later) for 20 years, when the accumulation phase ends, you’d then be able to start receiving those promised payments, according to the terms of your annuity.

Types of annuities

There are three main types of annuities, and how payments are made differ accordingly:

Fixed annuities

This is the most common type of annuity, according to Justin Pritchard, a Certified Financial Planner (CFP) and Retirement Management Advisor (RMA) at Approach Financial Planning, and how they work may be most familiar to people.

“It can create a lifetime stream of income that looks and feels like what they used to get while working,” says Pritchard. The insurance company promises you a specific rate of return on your investment, and provides you with monthly fixed payments.

Variable annuities

Payments you receive under a variable annuity change with the market. So when returns are high, you might get larger payments than you would with a fixed annuity. But you could also get lower payments when the market takes a dip, so there’s more risk. Variable annuities make sense as a long-term investment rather than a short-term one since they would be better able to ride out market highs and lows.[1]

Indexed annuities

Similar to a variable annuity, indexed annuities provide returns that are based on market performance. In this case, it’s tied to the performance of a stock market index. You could either get periodic payments or a lump sum with this kind of annuity. They also carry more risk than a fixed annuity.[3]

Tip: Fixed and indexed annuities are regulated by state insurance commissions, while variable ones are overseen by the Securities and Exchange Commission (SEC).[1] You can research the annuity company you are considering with each regulatory organization.[4]

Are annuities right for you?

People often buy fixed annuities as they enter retirement because they can provide guaranteed payments, notes Pritchard. How much money to put into an annuity depends on the payments you want to get out of it.

For example, if you want to get a guaranteed payment of $500 per month, you’d use that information to decide how much money to invest in an annuity, based on the returns companies are offering.

On the other hand, if you’re someone who’s retiring with an ample amount of funds, a fixed annuity probably wouldn’t make sense for you since you wouldn’t necessarily need the predictability of the product’s payments (and you could avoid the fees).

Annuities can also be used to cover certain known expenses, like a mortgage, in retirement. So for example, if you had $100,000 left on your house with a 10-year mortgage, you might set up an annuity to cover those payments until you own it outright. That way, you would be able to use your fixed income to pay for other living expenses and you wouldn’t have to worry about running out of money to put toward that large expense.

When it comes to variable and indexed annuities, Pritchard is more skeptical since “the upside might be less than you think,” due to the increased risk involved.

However, there are times when purchasing them might be the right move. “If people are comfortable taking on risk, want to grow their money as much as possible, but are open to the risk of losing it, then a variable annuity might make sense,” he says. Indexed annuities might also make more sense for someone who wants to maximize their investment.

Potential drawbacks to annuities

As good as a steady stream of income during retirement sounds, there are some negatives you should be aware of with annuities:

Fixed annuities might not keep up with inflation

When it comes to retirement planning, you can use historical inflation data to estimate your future cost of living. But inflation is unpredictable. For example, the annual U.S. inflation rate ranged from about 1.5% to 2.5% from 2012 through 2020. But 2022 saw a sharp spike up to about 6% in January.[5] So if your annuity’s interest rate is less than 6%, it wouldn’t be able to keep up.

There are fees

Depending on the annuity you go with, you may end up paying a mortality and expense risk charge (often this is about 1.25% of your account value). There can also be administrative fees and fees associated with the underlying fund you’re investing in. And you may even pay a fee for guaranteed payments.[1] That’s why it’s a good idea to ask for a complete explanation of all fees associated with a given annuity and how that would impact future payouts.

Taxes and annuities

Tax-deferred annuities mean you reduce your taxable income by contributing pre-tax funds to an annuity premium. Annuities are taxed at the time of withdrawal regardless of the type of annuity purchased. The amount of taxation varies depending on whether you purchased an annuity with pre-tax dollars or not.[6]

You do not owe income taxes on your annuity until you withdraw money or begin receiving payments. When you do take money out, it will be taxed as income if you purchased the annuity with pre-tax funds. However, if you bought your annuity with post-tax funds, you only pay tax on the earnings. Pretty nifty.

Now, have you inherited annuity earnings? Those will be subject to taxation.

Surrender charges and annuities

What happens if you want to sell or withdraw money from an annuity before you’re supposed to? You will be fined a “surrender charge.” There may be exceptions like death benefits, nursing home admission and terminal illness. Note that some companies offer no-surrender annuities, and some contracts include bail-out provisions that take effect under certain circumstances.[7]

Surrendering your annuity will also trigger the income tax that has been deferred up until that point.

Your plans may change

Annuities often lock you into a certain timeline. For example, if you agree to make payments until you reach retirement, then you can start cashing in on those guaranteed payments. But “your plans might change in four years, and if you’re locked into a 10-year surrender schedule, that’s a problem,” says Pritchard. In that case, you could then surrender the annuity, but you’d potentially pay a surrender charge which would eat into your investment’s value.

Insurance companies can go under

“It’s up to the strength of the insurance company,” says Pritchard. “So if the company goes belly up, you might lose assets. You really want to make sure you choose a good insurance company.” That’s why it’s important to check the financial strength of the insurer when shopping for annuities. You can do that by looking at ratings from places like A.M. Best and Standard & Poor’s insurance ratings services.

Article Sources
  1. “Annuities,” U.S. Securities and Exchange Commission, https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/annuities.
  2. “Variable Annuity Surrender Charges,” U.S. Securities and Exchange Commission, https://www.investor.gov/introduction-investing/investing-basics/glossary/variable-annuity-surrender-charges.
  3. “Indexed Annuities,” U.S. Securities and Exchange Commission, https://www.investor.gov/introduction-investing/investing-basics/glossary/indexed-annuities.
  4. “Annuity Regulations,” Annuity.org. https://www.annuity.org/annuities/regulations.
  5. “Databases, Tables & Calculators by Subject: CPI for All Urban Consumers (CPI-U),” U.S. Bureau of Labor Statistics, https://data.bls.gov/timeseries/CUUR0000SA0L1E?output_view=pct_12mths.
  6. “Annuity Taxation.” Annuity.org. May 23, 2022. https://www.annuity.org/annuities/taxation/#:~:te
  7. “Annuity Surrender Charges.” Annuity.org. April 25, 2022. https://www.annuity.org/selling-payments/surrendering/#:~:text=A%20%E2%80%9Csurrender%20charge%E2%80%9D%20is%20a,deferred%20up%20until%20that%20point.

About the Authors

Devon Delfino

Devon Delfino

Devon Delfino is a writer who’s covered personal finance—including everything from student loans to budgeting to saving for retirement and beyond—for the past six years. Her financial reporting has appeared in publications like the L.A. Times, U.S. News and World Report, Teen Vogue, Masha

Full bio
Elaine King

Elaine King CFP®

Elaine has served as the Family’s Financial Planner for over 1,200 families and 100 multigenerational family enterprises crafting actionable family financial plans.

Full bio

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