Annuities Explained: How They Work, Their Costs and Who They Suit

Annuities are often pitched as a way to never run out of money in retirement. For some people, they can be a useful tool. But annuities come in many forms, and some are complex, expensive and difficult to understand. Before buying an annuity, it’s important to understand how they work, what they cost and whether they fit your needs.

What an annuity is

An annuity is a contract with an insurance company. You pay the insurer a lump sum or a series of payments, and in return, the insurer promises to make payments to you, either starting right away or at some point in the future. Payments may last for the rest of your life, for a set number of years or for the lives of you and a spouse.

In essence, annuities can turn a lump sum of savings into a stream of income. Because some annuities provide lifetime income, they can protect against the risk of outliving your money, which is known as longevity risk.

The main types of annuities

Annuities can be categorized by when payments begin and how returns are determined.

Immediate annuities start paying income soon after you buy them, typically within a year. You give the insurer a lump sum, and it begins making regular payments. Single premium immediate annuities are often the simplest type.

Deferred annuities grow over time and start paying income later. During the accumulation phase, your money grows on a tax-deferred basis. Later, you can convert it into a stream of income or withdraw it.

Fixed annuities pay a set interest rate during the accumulation phase or provide a set amount of income. They offer predictability and are generally simpler.

Variable annuities let you invest in subaccounts, similar to mutual funds. Your returns and income depend on the performance of the underlying investments, so they can rise or fall. Variable annuities often come with optional riders that provide guarantees, for an additional cost.

Indexed annuities, sometimes called fixed indexed annuities, tie returns to the performance of a market index, such as the S&P 500, usually with limits on both gains and losses. They often include caps, participation rates or spreads that limit how much of the index’s gains you receive, while protecting against losses. These features can be complex.

Potential benefits

The biggest potential benefit of annuities is guaranteed income that you can’t outlive, depending on the type of annuity. Some retirees use annuities to cover essential expenses, such as housing, food and health care, alongside Social Security and any pension. Knowing these essentials are covered by guaranteed income can provide peace of mind and make it easier to handle market ups and downs with the rest of your savings.

Deferred annuities also offer tax-deferred growth, though there are no contribution limits like those for 401(k)s and IRAs, which can appeal to people who have maxed out other retirement accounts.

Costs and catches

Fees for some annuities, especially variable annuities with extra features, can be high. Costs may include mortality and expense risk charges, administrative fees, fees for underlying investment options and charges for optional riders, such as guaranteed income or death benefits. These fees can add up and significantly reduce returns over time.

Surrender charges can apply if you withdraw money in the early years of the contract, often for several years. These charges can be substantial and typically decline over time.

Your money may be locked up and less flexible. Once you convert savings into an income stream, you may not be able to access the lump sum if you need it for an emergency. Withdrawals from deferred annuities before age 59½ may also be subject to a 10% tax penalty, in addition to income tax on earnings.

Inflation can erode the value of fixed payments over time unless you buy an inflation-adjusted option, which typically costs more or pays less initially.

Guarantees depend on the insurance company’s financial strength. Annuities aren’t insured by the FDIC. State guaranty associations provide some protection if an insurer fails, up to certain limits, but it’s important to choose a financially strong insurer. Independent rating agencies assess insurers’ financial strength.

Annuities can also be complex, and sales practices have drawn regulatory scrutiny. The Securities and Exchange Commission and the Financial Industry Regulatory Authority offer free investor guides on annuities that explain these features in detail.

Who might consider an annuity

Annuities may suit people who want guaranteed lifetime income beyond Social Security, are worried about outliving their savings, have enough other savings for emergencies and flexibility, and value predictability over potential growth. They may be less suitable for people who need access to their money, have limited savings or are uncomfortable with complex products.

Before you buy

Ask how the seller is paid. Many annuities pay sales commissions, which can create conflicts of interest. Compare quotes from multiple insurers, since payments and terms vary. Read the contract carefully, including fees, surrender charges and how guarantees work. Many states offer a free-look period, during which you can cancel a new annuity for a full refund.

A fee-only fiduciary adviser, who is legally required to act in your best interest and doesn’t earn commissions, can offer an unbiased opinion on whether an annuity makes sense for you.