Annuities are a common tool for retirement planning, especially for those who want to ensure they have steady income during their golden years. But what is the primary reason for buying an annuity? For most people, it’s guaranteed lifetime income—a way to protect against running out of money in retirement. However, the benefits of annuities don’t stop there. They can also help with tax-deferred growth, risk management, and peace of mind.
In this article, we’ll explore the primary reasons for purchasing an annuity, the different types available, key considerations, and viable alternatives to help you make an informed decision.
What Is An Annuity?
An annuity is a contract between you and an insurance company. You pay a lump sum or series of payments to the insurer, and in return, you receive regular income payments in the future. These payments can be for a fixed period or for the rest of your life, depending on the type of annuity.
Types Of Annuities
Understanding the different types of annuities is essential to finding the right fit. Each type has distinct benefits—and potential downsides.
1. Fixed Annuities
Fixed annuities are the simplest and most predictable type of annuity. They provide a guaranteed return on your investment, making them ideal for individuals who prioritize stability and a reliable income stream.
How Fixed Annuities Work
- When you purchase a fixed annuity, the insurance company agrees to pay you a guaranteed interest rate on your contributions. Depending on the contract terms, payments can begin immediately or in the future.
Benefits of Fixed Annuities
- Predictable Income: Fixed annuities provide regular, predetermined payments, which can be a dependable source of income in retirement.
- Low Risk: These annuities are not tied to market performance, making them a safe option for risk-averse individuals.
- Tax-Deferred Growth: Earnings within a fixed annuity grow tax-deferred, allowing investment to compound over time.
Potential Drawbacks
- Lower Returns: Fixed annuities may offer lower returns than other investments, especially during low interest rates.
- Inflation Risk: Fixed payments may remain unchanged over time, which can lead to a decline in purchasing power as the cost of living increases.
- Fees: administrative fees, underwriting fees, investment fees, commission fees and surrender charges or other penalties may come along with all annuities, including fixed.
Best For: Retirees or conservative investors seeking a stable, predictable income with minimal risk.
2. Variable Annuities
Variable annuities offer the opportunity for higher returns by allowing you to invest in a range of subaccounts, which are similar to mutual funds. However, the payments you receive will fluctuate based on the performance of these investments.
How Variable Annuities Work
When you purchase a variable annuity, your money is invested in subaccounts chosen from a menu of options provided by the insurer. These subaccounts may include stock, bond, or balanced funds. The performance of your investments determines the size of your future payouts.
Benefits of Variable Annuities
- Growth Potential: Unlike fixed annuities, variable annuities offer the potential for higher returns tied to market performance.
- Tax Advantages: Earnings grow tax-deferred until withdrawals begin, allowing for compounding growth.
- Customizable Investment Options: You can tailor your portfolio to match your financial goals and risk tolerance.
Potential Drawbacks
- High Fees: Variable annuities often come with significant costs, including fund management fees, administrative fees, and mortality and expense charges, which can eat into returns.
- Investment Risk: While there is potential for growth, poor market performance can result in lower payouts or even losses.
- Complexity: Variable annuities are more complicated than fixed annuities, requiring careful consideration of investment options and fees.
Best For: Investors comfortable with market risk who are seeking growth opportunities alongside potential retirement income.
3. Immediate Annuities
Immediate annuities are designed for those who need income right away. They convert a lump sum into a steady stream of payments, which begin shortly after the purchase.
How Immediate Annuities Work
You provide the insurer with a lump sum, and they start making payments to you almost immediately—usually within a month.
Benefits of Immediate Annuities
- Quick Access to Income: Payments begin almost immediately, making this type of annuity ideal for retirees who need income immediately.
- Lifetime Payments: You can choose a lifetime payout option to ensure you never outlive your income.
- Simplicity: Immediate annuities are straightforward, with no need to manage investments or worry about market fluctuations.
Potential Drawbacks
- Illiquidity: Once you purchase an immediate annuity, you typically cannot access the principal amount.
- Fixed Payments: Payments are often fixed, meaning they may lose value over time due to inflation.
- No Growth Potential: There’s no opportunity for the initial investment to grow, as all returns are predetermined.
- Fees
Best For: Retirees with a lump sum to invest who want guaranteed, immediate income to cover living expenses.
4. Deferred Annuities
Deferred annuities are designed for individuals who don’t need income immediately but want to grow their investment over time. These annuities provide flexibility and tax-deferred growth during the accumulation phase.
How Deferred Annuities Work
When you purchase a deferred annuity, your money grows within the annuity until you’re ready to begin receiving payments. This can be years or even decades later, depending on your retirement timeline.
Benefits of Deferred Annuities
- Tax-Deferred Growth: Investments grow tax-deferred, which can result in significant compounding over time.
- Customizable Payout Timing: You can choose when payments begin, offering flexibility to match your retirement needs.
- Flexible Investment Options: Deferred annuities come in fixed, variable, and indexed varieties, allowing you to select the best fit for your risk tolerance and goals.
Potential Drawbacks
- Liquidity Concerns: Deferred annuities typically come with surrender charges for early withdrawals.
- Fees: Depending on the type of deferred annuity, fees can add up and reduce your returns.
- Delayed Access: Since income starts later, these annuities are less suited for those with immediate income needs.
Best For: Younger investors or those planning for retirement who want to maximize tax-deferred growth and establish a future income stream.
Why Do People Buy Annuities?
The primary reason people purchase annuities is to insure themselves against the risk of outliving their savings. This is often referred to as managing longevity risk.
- Guaranteed Lifetime Income
Annuities provide a stable, predictable income stream for as long as you live, regardless of how the markets perform.
- Longevity Risk Management: Life expectancy is increasing, making it essential to plan for a retirement that could last 20 to 30 years—or more. Annuities ensure you won’t outlive your savings.
- Fixed Guaranteed Income: Before purchasing an annuity, ask yourself: How much fixed income do I need to cover my essential expenses in retirement? Annuities can fill the gap if Social Security and other sources of income fall short.
- An Alternative to Stock Market Investments
If investing in stocks or bonds feels too risky, an annuity may offer a safer alternative.
- Risk-Averse Investors: Many people are uncomfortable with market volatility, especially as they near retirement. Annuities provide a way to avoid this risk while securing a reliable income stream.
- Stability Over Growth: While stocks may offer higher returns, the predictability of an annuity appeals to those who prioritize financial stability.
- Tax Advantages
Annuities offer some tax advantages:
- Tax Deferred Growth: Your earnings grow tax-free until you start making withdrawals. This can help your investment compound over time.
- Tax Treatment Upon Withdrawal: When you start receiving payments, the portion representing earnings is taxed as ordinary income, while the portion representing your principal contribution is typically tax-free- you have already paid taxes on the principal.
- Supplement to Retirement Accounts: If you’ve maxed out your 401(k) or IRA contributions, an annuity can be a tax-efficient way to save more for retirement.
It is essential to consult with a tax advisor to understand the implications for your specific situation.
Why We Don’t Recommend Annuities For Everyone
While annuities offer benefits, they aren’t the right choice for everyone. Here are a few reasons why we often don’t recommend them:
- High Fees and Surrender Charges: Annuities, especially variable annuities, can come with hefty fees, including administrative costs, fund fees, and optional rider fees. There are also surrender charges. If you decide to withdraw your money early or change your mind about the annuity, you may face significant penalties. These charges can last for several years, so be sure you’re confident in your decision before committing.
- Limited Liquidity and Access: Annuities are long-term commitments, and accessing your money can be difficult without incurring penalties.
- Inflation protection: Standard fixed annuities may not keep up with inflation, potentially eroding your purchasing power over time. Options like variable or inflation-adjusted annuities can help address this concern but may come with additional costs.
- Financial Stability of the Insurer: Since annuities depend on long-term payouts, choosing an insurance company with a strong financial rating is vital. Research the provider’s history and reputation before purchasing.
- Better Investment Options: Younger investors or those with a higher risk tolerance may achieve greater growth by investing in stocks or diversified portfolios.
- Taxes on Beneficiaries: When an annuity is passed on to a beneficiary, the tax burden is determined by the original purchase price (also known as the cost basis) and the gains accumulated during the contract’s life. Unlike other investments, annuities do not receive a “step-up in basis” at the time of inheritance.
Rather than solely depending on an annuity, explore whether your income needs can be met through a mix of Social Security benefits, pension plans, and personal savings, or by leveraging other investment options. You can annuitize an investment account, which will provide regular payments without the fees that come with an annuity. Partnering with a fee-only financial advisor can provide you with a tailored, comprehensive financial plan designed to align with your long-term financial goals and priorities.
Exploring Annuity Scenarios
How an Annuity Provided Lifetime Security
Scenario: Maria, a 65-year-old retiree, was concerned about running out of money during retirement. She had $300,000 in savings and wanted to ensure she had enough income to cover essential expenses, like housing and healthcare, for the rest of her life.Solution: Maria purchased a fixed immediate annuity of $200,000, which guaranteed her a lifetime monthly income of $1,200. This, combined with her Social Security benefits, provided her with a stable cash flow to enjoy a comfortable retirement without financial stress.
When an Alternative Investment Was Better
Scenario: David, a 45-year-old professional, had maxed out his 401(k) contributions and was exploring options to grow his savings. While an annuity seemed appealing for its tax advantages, he was concerned about liquidity and high fees.Solution: David opted to invest in a diversified portfolio of stocks and bonds through a taxable brokerage account. This gave him higher growth potential and immediate access to his funds. The flexibility of his portfolio allowed him to adjust his investments based on market conditions and personal goals.
Alternatives to Annuities
If annuities don’t align with your financial goals, several alternative options can provide income in retirement while offering more flexibility and potentially better tax advantages. Here are some popular alternatives:
- Investment Portfolios: Diversified stocks and bonds offer growth and income.
- Dividend-Paying Stocks: Provide a steady income stream with growth potential.
- Real Estate Investments: Rental properties or REITs generate passive income.
- Roth IRAs: Tax-free withdrawals and no required minimum distributions.
- Certificates of Deposit (CDs): Offer fixed interest rates without market risk.
- Health Savings Accounts (HSAs): Triple tax benefits for qualified medical expenses.
Steps To Determine If You Need an Annuity
If you’re considering an annuity, take the following steps to ensure it’s the right decision:
- Evaluate Your Fixed Income Needs
Determine how much guaranteed income you’ll need in retirement to cover essential expenses. This includes housing, healthcare, and daily living costs. - Assess Your Risk Tolerance
If you’re uncomfortable investing in stocks or bonds, an annuity might provide the necessary stability. However, weigh this against the potential for higher returns from other investments. - Understand the Costs
Review the fees, surrender charges, and other costs associated with the annuity. Ensure the benefits outweigh the expenses. - Consult a Financial Professional
An experienced fiduciary financial advisor can help you decide whether an annuity aligns with your retirement strategy.
Frequently Asked Questions About Annuities
1. Are annuities a good investment?
Annuities are a good choice for individuals seeking guaranteed income and tax-deferred growth. However, they may not be ideal for those prioritizing liquidity or high returns.
2. Can I lose money in an annuity?
It depends on the type of annuity. Fixed annuities offer principal protection, while variable annuities expose you to investment risk. The long-term financial stability of the insurance company is an important consideration.
3. How much does an annuity cost?
The cost varies based on the type and features of the annuity. Fees can range from 1% to 3% annually, and surrender charges may apply for early withdrawals.
Is An Annuity Right For Me In 2025?
The primary reason for buying an annuity is to ensure guaranteed income for life, making it an effective tool for managing longevity risk and providing peace of mind during retirement. However, annuities are not without their drawbacks. High fees, surrender charges, and limited liquidity make them less suitable for some individuals. Before purchasing an annuity, evaluate your financial needs and explore alternatives.
If you want a comprehensive financial plan, schedule a free discovery call with one of our financial planners today.
Alvin Carlos, CFP®, CFA is a fee-only financial planner, in Washington, D.C. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is the founder of District Capital, a financial planning firm designed to help professionals in their 30s and 40s maximize their money and retire by 55, through holistic financial planning and research-driven investing. Schedule a free discovery call today.
