What are annuities and how do they work?

One of the biggest risks in retirement is the possibility of outliving your savings. What if you didn’t save quite enough during your working years, your investments underperformed or you picked the wrong withdrawal strategy?

Annuities are a financial product meant to protect against longevity risk, or the possibility of outliving your money in retirement. You hand over a lump sum or series of payments to an insurance company, and in exchange, the insurer takes on the risk and promises a series of payments to you either now or years in the future. 

Because they can provide predictable income, annuities are a popular approach to retirement planning, especially as pensions have become less common in the private sector. 

However, annuities have their share of drawbacks, such as high fees and complex contracts, which is why it’s essential to understand all the pros and cons before moving forward.  

Here’s how annuities work and what to consider before purchasing an annuity. 

What is an annuity?

An annuity is a contract with an insurance company that provides a stream of income, typically in retirement, in exchange for money paid into the annuity. You can purchase an annuity by depositing a lump sum or by making a series of premium payments over time. People often invest in annuities as part of their broader retirement strategy.

Sold as an insurance product, annuities pay out on a predictable schedule. That’s why these financial products are sometimes referred to as a “paycheck replacement.” These retirement paychecks can last for a specific period, such as 10 or 20 years, or for the rest of your life, depending on how the annuity contract is structured.

Most annuities have two phases — the accumulation phase and annuitization, or the payout phase. In the accumulation phase, you’re putting money into the annuity as a lump sum or payments over time. In the annuitization stage, you’re taking payouts from the annuity.

Money deposited into an annuity is locked up for a time called the surrender period. If you decide you want out of the annuity early, you’ll pay a hefty fee called a surrender charge.

Types of annuities

There are three basic types of annuities. Each type describes how an annuity generates a return.  

• Fixed: A fixed annuity guarantees you a minimum rate of return on your investment and will pay out over a fixed term.
• Variable: A variable annuity allows you to put your money into various investments, often mutual funds. What the annuity returns and pays out to you can fluctuate and depends on how the investments perform and the expense ratios on any funds you invest in.
• Indexed: An indexed annuity offers a rate of return that tracks an index such as the S&P 500, which holds hundreds of America’s largest companies.

Additionally, annuities can also be classified by when they pay out.

• Deferred annuities pay out at some specified time in the future, perhaps in retirement.
• Immediate annuities begin paying out within a year or less of purchase.

In the table below, you can see how the three main types of annuities compare based on key benefits:

Annuity riders

Annuities can be structured in many different ways, depending on your needs. These optional features are called riders and provide a higher level of benefits — at a cost. Generally, the more riders your annuity has, the pricier it is.

Some annuities can guarantee you’ll receive a specific amount from the account over a period of time. Other riders provide a death benefit that pays out after you die or survivor’s benefits, where a spouse can continue receiving payments. 

So while the company issuing the contract has many different ways to create the annuity based on your needs, you’ll pay extra for all the benefits.

Tax advantages of an annuity

Qualified annuities offer tax-deferred growth on your investment until you withdraw the money or begin receiving payments. This feature can be valuable for those looking for a tax-advantaged way to save for retirement. If you fund a nonqualified annuity with after-tax money, you’ll be taxed at withdrawal only on the earnings, not any principal that you take out. 

Like other tax-deferred retirement accounts, such as a traditional 401(k), qualified annuities have annual contribution limits but nonqualified annuities — like brokerage accounts — have no limits. That’s a particular benefit for higher-income savers, who may otherwise want to contribute more to their retirement but have maxed out a 401(k) or IRA. 

You can also buy an annuity inside a Roth IRA or Roth 401(k), making those payouts entirely tax-free. However, many experts frown on putting a complex tax-advantaged account inside another tax-advantaged account, such as a Roth IRA. After all, there’s no additional tax benefit to doing so. 

The downside of annuities

An annuity can solve the challenge of outliving your savings and may offer some other benefits, such as a death benefit. However, annuities come with downsides, and many financial advisors may be skeptical of annuities for the following reasons. 

Complexity

Annuity contracts are notoriously complex, often totalling dozens of pages. In the fine print, you’ll find the many conditions of the annuity spelled out, such as when you can get paid, how much it will cost you to cancel the contract, the guaranteed payment, what rate of return you can expect and all the other details that govern the agreement.

On top of this complexity, annuity contracts may differ markedly from one to the next. Annuities have some broad similarities, but the devil is in the details. Insurance companies may offer a specific kind of coverage that you’re looking for while burying the less flattering details deep within the contract.

You’ll need to read the agreement closely to understand your rights and responsibilities. But even spending hours on the contract may not be enough to fully grasp all the conditions. It may be best to seek help from a third-party financial advisor.

High sales commissions

One of the most significant drawbacks of an annuity is the large sales commission baked into the product. While you may not pay the commission directly, it still reduces the returns you otherwise could have earned.

Unfortunately, it’s not unusual to spot a commission at 6 or 7 percent, though it may go up to 10 percent. If you put $100,000 into an annuity, a salesperson may take $6,000 or more, though the insurance company may obscure how you’re charged.

Complex annuities with more features generally have higher commissions than simple annuities. An annuity with an extended surrender charge period may mean higher commissions, too.

With that kind of incentive, it’s little wonder that insurance agents may be eager to sign up clients in a complex product. It’s also why you may want to consider getting a second opinion from an independent fee-only financial advisor who’s looking out for your best interest.

Illiquid asset that’s difficult to cancel

Once you put your money into an annuity, it’s generally tied up for an extended period. You’ll receive your income stream, and may be able to withdraw some of the principal, but for the most part, your money is locked into the annuity and you have relatively little access to it.

If you decide you want to get out of your annuity, you’ll likely face substantial fees called surrender charges. Surrender charges typically last six to eight years after signing the annuity contract, and tend to decrease over time. 

You can also choose to sell your annuity payments. There are several reasons you may choose to sell the payments, like an unexpected medical emergency arises or your dream home comes on the market, but the decision shouldn’t be taken lightly. A factoring company will apply a discount rate to the payments you sell, meaning you’ll never receive the full amount of what your future payments are actually worth. 

While there may be ways for you to wiggle out of an annuity contract, don’t expect them to be easy or free. That can be problematic if you need money for an emergency and your income or other savings don’t suffice.

Risk

Because they may rely entirely on the markets for any gain, variable annuities are especially risky, potentially leaving you with few gains and maybe even losses after years of saving. You’ll want to invest any money for the long term to ride through the dips in the market and avoid fees that may come with an early withdrawal.

Variable annuities tend to have the highest fees too — a mortality and expense risk charge, the expense ratios of any funds you invest in, administrative fees and any additional fees for special riders you’ve added to the account (for example, a death benefit or guaranteed minimum payout).

And suppose you withdraw your money early, before age 59 ½. In that case, you can get hit with a 10 percent penalty from the IRS in addition to taxes you’ll owe on any investment gains, much like the penalties for early withdrawals from traditional IRA and 401(k) accounts.

Alternatives to annuities

So many kinds of annuities exist because consumers have varying needs. But ultimately, annuities aren’t the right choice for everyone. Here are some alternatives to annuities.

• Investment portfolio: Strategic investments can help provide extra income during retirement. For example, while an annuity may promise you a 4 percent return on your money, a financial advisor may be able to construct a portfolio that earns you 5 percent today and offers a growing stream of dividends in future years. Or you could use a robo-advisor to create a balanced portfolio for you at a fraction of the cost.
• Certificate of deposit: CDs are another relatively safe way to save for retirement. CDs usually require that you leave your money untouched for a set term, after which you can withdraw the principal and interest. You pay taxes on the interest annually, even if you haven’t received the money yet.
• Managed payout fund: A managed payout fund is similar to an annuity, but there is no guaranteed rate of return on your money. Managed payout funds are a type of mutual fund that can yield anywhere from 1 percent to 8 percent growth.
• Life insurance policy: Certain types of life insurance can provide income replacement during retirement, usually through riders. Life insurance policies also have a death benefit that your loved ones can access after you pass away.

Annuity FAQs

What are the benefits of purchasing an annuity?

One of the most significant benefits of an annuity is that it allows you to put money away for retirement. The money grows tax-free, which maximizes the account’s growth potential. If you choose a fixed annuity, you will get a guaranteed rate of return on your money, which limits risk. Another major benefit is that after you purchase an annuity, you don’t have to worry about managing your investments or withdrawal strategies. The insurance company will take care of that for you. This can be a huge relief if you’re not comfortable managing your own portfolio or you want to simplify your retirement plan. 

What is a surrender period?

An annuity surrender period is the duration of time that an investor must wait to withdraw money from the account without being penalized. The surrender period depends on several factors, including your insurance company and the type of annuity you own. If you withdraw money during the surrender period, you will likely have to pay a hefty fee.

Bottom line

Annuities can be a good decision for the right person at the right time, but they come with substantial downsides that you should understand before signing a contract. Consider working with a financial advisor who can help you determine your long-term financial goals, investment strategy and help you decide if an annuity is the right fit for you. 

— Bob Haegele contributed to an earlier version of this story.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.