When planning for retirement, many people focus on building their savings through 401(k)s, IRAs, and other investment accounts. However, one financial tool often overlooked—yet potentially powerful for retirement income—is the annuity. Designed to provide a steady stream of income, annuities can be an effective way to ensure you don’t outlive your savings. But they’re not for everyone. Understanding what annuities are, the types available, and their advantages and disadvantages can help you decide if they’re the right choice for your financial future.
An annuity is a contract between you and an insurance company in which you pay a lump sum or series of payments in exchange for regular income payments in the future. The core purpose of an annuity is to provide guaranteed income—often for the rest of your life—starting either immediately or at some point in the future.
Annuities are commonly used as a way to supplement retirement income and offer a sense of security for those worried about outliving their savings. They can be thought of as the opposite of life insurance: while life insurance protects against dying too soon, annuities help protect the risk of outliving your savings.
There are several types of annuities, each with unique features and purposes. Understanding these variations are crucial in determining which may best suit your goals:
With an Immediate Annuity, you begin receiving payments shortly after making a lump-sum payment. This is often used by retirees who want to convert a portion of their savings into a predictable income stream right away.
Payments from Deferred Annuities begin at a later date—typically years in the future. This allows the investment to grow over time, often with tax-deferred growth.
A Fixed Annuity provides regular, guaranteed payments and has a set interest rate for the accumulation phase. It’s considered lower-risk and offers stable returns, making it a conservative choice for risk-averse investors.
Pros: Predictable income, safety of principal, simplicity.
Cons: Lower returns, less inflation protection.
With a Variable Annuity, your payments are tied to the performance of underlying investments, usually mutual funds. This means your income can grow with the market—but also decline during downturns.
Pros: Potential for higher returns, investment flexibility.
Cons: Higher fees, more complex, risk of loss.
Indexed Annuities offer returns based on a stock market index (like the S&P 500), but with a cap and a guaranteed minimum. They aim to balance risk and reward by giving some market upside without the full downside exposure.
Pros: Partial market gains, protection from losses.
Cons: Caps on gains, complex formulas, limited liquidity.
Lifetime Annuities pay income for the rest of your life, regardless of how long you live, while
Term-Certain Annuities pay for a fixed period (e.g., 10 or 20 years), after which payments stop.
You can also choose joint-and-survivor options for either that continue payments to a spouse after your death.
Pros of Purchasing an Annuity
The biggest appeal of annuities is the promise of regular, guaranteed payments—something no investment portfolio can promise. This could offer a sense of security, especially in retirement. Annuities are a form of insurance against outliving your savings. With lifetime annuities, you’ll receive payments no matter how long you live.
Like IRAs and 401(k)s, annuities allow your money to grow tax-deferred. You don’t pay taxes on earnings until you withdraw them, which can be helpful for long-term compounding. Unlike IRAs and 401(k)s, there are no contribution limits and no required minimum distributions.
Annuities can be tailored with various riders—such as death benefits, inflation protection, or long-term care provisions—allowing you to design them around your needs and can be useful estate planning tools.
Cons of Purchasing an Annuity
Some annuities, particularly variable and indexed annuities, come with high fees that can eat into your returns. These may include administrative fees, mortality and expense risk charges, and investment management fees. Annuities are not as flexible as traditional investment accounts. Early withdrawals can trigger surrender charges. Many annuities—especially indexed and variable ones—are complex and can be hard to understand. The fine print matters, and it’s not always easy to know exactly how your money will perform. Fixed annuities may not keep up with inflation unless you purchase an inflation rider. Otherwise, the real value of your income may decrease over time. Because of their guarantees and costs, annuities often produce lower returns compared to investments like stocks or mutual funds, especially over long periods.
Is an Annuity Right for You?
Annuities can make sense for certain individuals, particularly those nearing retirement who prioritize security over growth, or those without other sources of guaranteed income like a pension. They may also be a good fit if:
- You’re concerned about running out of money in retirement.
- You’ve maxed out other retirement accounts.
- You want to reduce market risk in your portfolio.
- You value predictability over performance.
However, annuities are not ideal for everyone. Younger investors, for example, may be better off focusing on growth-oriented investments with greater liquidity. Likewise, if you already have adequate income streams (like Social Security and a pension), an annuity may be unnecessary.
Annuities are a powerful tool in the retirement and estate planning toolbox, offering the benefit of guaranteed income. But they’re also complex products with trade-offs, such as high fees and reduced flexibility. Before purchasing an annuity, it’s important to understand the different types, assess your financial goals, and perhaps consult a financial advisor to determine whether it aligns with your overall plan.
By educating yourself on how annuities work and weighing their pros and cons, may help you make a more informed decision about whether they have a place in your retirement strategy.