What Are Annuities and Do They Make Sense for You?

You may have heard of annuities before, and wondered what are annuities and whether should you invest in them. Annuities have a reputation, and to a lot of finance people it isn’t a very good one. It’s a fact that an awful lot of financial advisors (not to be confused with annuity salesmen) don’t recommend them or even like to talk about them very much. They are more likely want to talk to you about investments in stocks, bonds, and mutual funds for growing your wealth. They’ll also talk about participating in a 401k plan to combine with your Social Security benefits, pension, and brokerage accounts for your retirement program.

Annuities can be confusing and have a pretty bad rep. But you should understand what annuities are before deciding on whether they're right for you.

That may be a good plan for many people. But it is wise to consider an annuity or at least feel that you have examined them and understood what they are and why you’d use them before you rule them out. For some people, it can be a real complement to their financial security and retirement plans. And that raises the question, “Do they make any sense for you?”

What Are Annuities?

First of all, you should understand what an annuity is before you reject the notion of “experts” that say they aren’t for you. An annuity is a cross between an insurance product and an investment. In some ways it is like a life insurance policy in that you can collect money when you die and you can name a beneficiary to get the money when you pass away. But, it is different from life insurance in many other ways. You invest money upfront in an annuity. You collect money from an annuity when you reach the agreed upon date and time of its maturity and continue to collect from it while you are alive. And that’s the point. It provides income for your retirement, year after year. But there is even more.

Unlike life insurance, the good news is that you don’t have to provide any medical information and you aren’t ever turned down for it. Also you should understand that the money you’ll be getting back is primarily your own money that you invest plus any interest and/or earnings that it has made.

Types of Annuities

There are several different types of annuities and in fact that can be a little confusing. I’m only going to highlight the surface of the major types here so that you will see that there are choices you can make and that each of these contracts has their own advantages and disadvantages to consider. There are two types of ways you can have earnings for annuities: fixed interest rates or variable interest rates. The interest rates on fixed will not vary and you will know exactly what you are going to have at the contract end but the rates are usually low and are best for long term contracts that have time on their side to grow. Variable rate annuities are invested based on activity in actual stocks and funds and therefore may gain or lose money. They have more reward potential (upside) along with greater risks (downside).

While you don’t pay premiums like you do for insurance, there are costs to an annuity that are different in the fixed and variable types of this investment. With variable contracts, there will be management fees that can run up to 2-3% annually and come right out of the value of it. That’s the fee that the issuers charge for managing it as they alter the investments when the market changes for both your and their own benefit. If you could do it yourself, it would require lots of time and knowledge and frankly not many people are capable of doing that kind of thing with great success.

Remember too that there are also commissions taken for your purchase of an annuity. You don’t see the commissions in most cases but they are there. You don’t see them because they aren’t being charged directly to you but are deducted and calculated as part of the long term earnings that the money you pay upfront will be earning over the term of the contract. There may also be a surrender charge if you decide to close an annuity before it matures (as much as 7% if you do that in the first year). Finally, there are the penalties for early withdrawals just like there are in a 401k or other retirement plans if you aren’t at least age 59½ when you begin to withdraw funds.

Annuity Options

There are also several options when you do finally “annuitize” and withdraw money from your account. You can pick a certain number of years for your payout, or you can take a lump sum or even have it portioned out monthly or annually for as long as you may live even if you live to be 100 or more. Every variation of the type of payout will alter the amount of money you will receive either monthly, quarterly, semiannually, or annually, and that is a decision that you make upfront yourself. Having a steady stream of income that is predictable and supplements your other retirement income is a real confidence booster for many people as it is for me since I own an annuity myself.

The Why’s of an Annuity

Annuities are a supplemental item only in many retirement plans and as a rule of thumb should only be a portion of your retirement fund plan (like 20-50% at the very most). They are funded with money that is tax deferred and the big plus is that there are no limits on that amount used for tax deferment. That’s unlike how much you can put away with 401k and IRA plans. That feature alone makes them very attractive to wealthier high earners who want to reduce their current taxes and invest more in their retirement while they are still in peak earning years.

You will pay taxes when you receive the money from an annuity just like with a traditional 401k or IRA plan (Roth IRA plans are not tax deferred and do not become taxable when they are redeemed). You also have the flexibility to exchange annuities if you like, and you have the advantage in the case of fixed annuities of knowing exactly what you will get in a predictable way 10, 20, even 30 years from now as your payment.

Annuities are very well suited for those who are closer to retirement age and can be issued for immediate payouts or deferred for a few years (5 years is a popular choice). And, keep in mind that they’re the only instrument that can offer a guaranteed lifetime income stream no matter how long you may live.

The Why-NOT’s of an Annuity

We touched upon the fact that it can be more costly to get an annuity rather that looking at other options there may be out there. One of the most confusing parts of an annuity can be figuring out how much it actually costs.

Another problem with annuities is that interest payments on fixed rate contracts are not very high. Often you hear financial experts refer to numbers like 2, 3 or 3.5% annual return on the annuities. Investments in annuities may require larger opening contributions than typical accounts like an IRA CD’s or investment brokerage accounts might.  Right now though, those annual annuity interest rates exceed the ones that banks in the USA offer, but beware of this please. Often, in ads, the annual payout rates are expressed as just that, a payout and do not reveal the actual interest rate it will earn. If you see something saying that you will get a payout of 6% annually for 20 years when you annuitize, keep in mind that is interest earned plus a part of your principal that is being paid to you. It is not 6% interest as you may at first think.

Annuities are only as good as the companies that are offering them, so it’s important to do your research on them before you make any investment. An annuity is not FDIC insured and has some risk. That risk is the safety of the company itself although many insurance companies have been in business for decades and decades without any problems. There are places like Moody’s and Standard and Poor’s as well as A.M. Best who rates them all regularly. They should all have ratings but look specifically for AA++ through to AA–.

My Own Situation

I personally have a deferred fixed annuity that I purchased two years ago at age 65. I will begin to collect a steady stream of income from it for at least 20 years when I reach age 70, and if I outlive that 20-year period it will continue for as long as I live even if it is to 100 or more. I like the comfort of knowing that I will continue to receive some benefit from it throughout my retirement years. If I die before age 70, my wife will receive the principal I have invested plus the fixed interest rate I contracted for of 3.35% annually as a lump sum payout. If I pass away between the first payout and the end of the 20-year certain period, she will inherit the unpaid balance and will have several options to get that money at that time.

I like that feature and since my wife is the beneficiary she will get any money I leave behind during the 20-year certain period and there will be a steady stream of income for her. Since she is much younger than I am, I wanted to insure that she can manage finances in my absence along with her other retirement fund sources.

So that’s the basics on annuities. You can check out a source like Annuities.org for lots more of this of information on rules, rates and ratings that is free and very helpful. I recommend it highly whether you eventually invest in an annuity or not.

What do you think? Is it worth looking at annuities for you and your spouse? Have you ever considered it at all? Do you think that your retirement planning is sufficient without annuities as a part of this plan?


  1. Dan Palmer

    Thanks for a balanced and unbiased breakdown of annuities! Sounds like they make for good guarantee of not outliving your savings in return for a small sacrifice in yield.

  2. Overall annuities get a bad rap but as you pointed out, they can be an effective tool. In terms of risk – this is the biggest takeaway for me: “Annuities are only as good as the companies that are offering them.” I’d definitely go with highly rated insurers.

    Having peace of mind in knowing you can count on the funds for both you and Suzanne is most important. Mr. Groovy picked the joint option for receiving his pension that provides for me if he dies first. This too is like an annuity in that the pension provides a sum of money on a regular schedule. And NY’s constitution insures all pension obligations are met so they get an A+++ rating from the House of Groovy!

  3. ARB

    I recommend that anybody looking for a fixed annuity make sure that the annuity has what’s called a GROP, or Guaranteed Return Of Premium. This way if there’s an emergency and you have to cancel the annuity and take back the funds, you’re guaranteed to get back every penny of what you put in. The surrender charges will not eat into your principal.

    Also remember that you can choose to have your interest rate on a deferred annuity guaranteed during the surrender period or for only a part of the surrender period. Similar to deciding whether to pick a 30 year fixed rate mortgage or a 5/1, 7/1, 10/1, etc, adjustable rate mortgage, the starting rate of the annuity will be higher the less time that rate is guaranteed. To be honest, just guarantee the rate for as long as you can because rates aren’t going up high enough or fast enough to justify doing anything else.

    Fixed annuities are great for those who haven’t been saving for retirement like they should and suddenly find themselves in their forties, fifties, and sixties with a ton of money in the bank but not enough growing in investments. They’re also great for those at those ages who want to get their money out of the markets but still secure some growth. Variable annuities I’m not as sold on; they’re for younger people who I think would be better served by either investing in a dividend growth strategy (my strategy), investing in a low cost index fund, or socking as much of their money away as possible into a 401k.

    It’s good that you are giving both sides of the annuity debate. So many TV/radio financial personalities like Suzie Orman dismiss annuities outright and it makes me wonder if they understand them at all. It also makes it harder for bankers and FA’s who sell annuities, not just because it makes it harder to make a sale, but because it gives the financial professional an undeserved reputation as an unscrupulous salesman looking to hawk any destructive financial product onto unsuspecting grandmothers throughout America. And that makes it hard to look out for the best interest of the customers, which is the fiduciary duty of any licensed finance professional.

    Thanks for a great article!

    ARB–Angry Retail Banker

  4. Christopher Hay

    Just a few weeks ago I was asking one of my friends about how annuities really work. He was not all that clear, all he really stated was, you pay a certain amount each month and at a certain age you get a monthly installment for the rest of your life. However you make it MUCH more clear, valuable information here Gary.

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