Annuities
What is an annuity, and why might I want one?
An annuity is a contract between you and an insurance company, designed to provide a steady stream of income. Its main job in a retirement plan is to address longevity risk — the risk of outliving your savings.
You make a lump-sum payment or a series of premium contributions, and the insurer uses those to fund future payments back to you.
Accumulation phase
You pay premiums and the money grows, usually on a tax-deferred basis.
Distribution phase
You start receiving regular income payments, either for a fixed period or for the rest of your life.
“Aren’t annuities bad?”
We have heard it too. The criticism usually comes down to two things: other accumulation methods such as stocks and bonds can outperform an annuity, and there is limited liquidity in the early years. Both are fair.
We never recommend variable annuities. So why do we often recommend an annuity as part of an overall retirement strategy? Because the job we are asking it to do is not to beat the market. It is to produce income that does not stop, so the rest of the portfolio can be left alone to do what it is good at.
The types
Single premium immediate annuity (SPIA)
Requires a one-time lump-sum premium in exchange for a lifetime income stream based on life expectancy. Most offer a period-certain option, which continues payments to a beneficiary if you do not live beyond the selected period. Income begins immediately, and once the premium is paid you no longer have access to that principal.
Fixed annuity
Provides a guaranteed or flexible rate for a predetermined term. The most popular is a five-year guarantee. Guarantees are subject to the claims-paying ability of the issuing insurance company.
Fixed index annuity
Lets you choose a market-linked index without direct exposure to market losses. Using a cap, spread or participation rate, you select an index that offers potential interest based on that index’s performance, typically with a floor that protects the contract value from index declines.
Variable annuity
Similar to mutual funds, variable annuities are invested directly in the market through sub-accounts. They are sold by brokers, carry significant fees — typically 3.5% to 5% annually — and carry market risk. They are complex, because they combine an annuity and an investment in a single contract. We do not recommend them.
Growth or income?
| Guaranteed income | Index-linked growth | |
|---|---|---|
| What you get | Lifetime income, paid monthly or annually | Interest credited from an index, subject to a cap, spread or participation rate |
| Cost | Most carriers charge a rider fee | Often no explicit annual fee, though some index options and riders do carry one |
| Extras | Often a guaranteed roll-up benefit and a long-term care feature that can activate later in life | Most carriers allow an annual withdrawal of up to 10% without surrender charge |
| Downside exposure | Income is contractual, subject to the insurer’s claims-paying ability | Floor protects against index declines; you still give up full market upside |
Why this matters in a downturn
Taking withdrawals during a falling market is the hardest problem in retirement income. It is very difficult to recover from withdrawals made while values are depressed — this is sequence-of-returns risk, and it is the reason a plan needs income that does not depend on what the market did last year.
Pros and cons
Can include
- Safety, with a 0% floor available
- Steady income stream
- Tax-deferred growth compounds returns
- Avoids probate
- No contribution limits
- Can participate in index returns
- Choice of indices and participation rates
- Often low or no explicit fees with fixed index annuities
But also
- Illiquid, particularly in early years
- High fees with variable annuities
- Inflation risk
- Early surrender charges
- Complexity of contract choices
- Limited market upside
Needs differ from person to person, and so do the right options. Which type fits — or whether one fits at all — is a question we answer by modeling your own numbers, not by starting from a product.
Want to see where an annuity would and would not help?
Annuities are insurance contracts, not bank deposits, and are not FDIC insured. All guarantees, including income riders and floors, are subject to the financial strength and claims-paying ability of the issuing insurance company. Annuities are long-term vehicles and typically carry surrender charges for a set number of years; withdrawals may be subject to those charges and, before age 59½, to a federal tax penalty. Indexed annuities limit credited interest through a cap, spread or participation rate, and you do not receive dividends on the underlying index. Product features vary by carrier and by state. Jeff Batson is a Registered Financial Consultant® licensed in life, health, annuities and Medicare; he is not an attorney, CPA, or securities-licensed advisor, and nothing here is legal, tax, or investment advice.