Annuities generate more heat than any other product in this business. One camp says they are the answer to retirement; the other says they are always a bad deal. Both are selling something — a product in the first case, an assets-under-management fee in the second.
The truth is duller. Annuities are contracts that transfer specific risks to an insurance company. When you have that risk and want it transferred, they work. When you do not, they are an expensive way to hold money.
This guide covers what each type does, how the contract terms actually work, and the analysis that decides whether you need one at all.
The problem annuities actually solve
Not returns. Two specific risks.
Longevity risk. You do not know how long you will live. Planning for 85 and living to 97 is a financial catastrophe; planning for 100 and dying at 79 means you underspent your entire retirement. No portfolio solves this, because the uncertainty is about you rather than about markets. Pooling it across many people — which is exactly what an insurance company does — turns an unknowable individual risk into a manageable actuarial one.
Sequence-of-returns risk. Two retirees can experience the same average annual return over thirty years and end up in completely different places, purely because of the order the returns arrived in. A poor first five years while you are withdrawing depletes the capital that would have compounded in the recovery. The same five bad years at the end of retirement are largely harmless.
You cannot diversify away the order of returns. What you can do is ensure you are not forced to sell into a falling market to buy groceries. That is what a guaranteed income floor achieves.
The question that comes before every product decision
What is this money’s job?
If the answer is “guarantee a floor under my retirement income,” an annuity is a legitimate tool. If the answer is “grow as much as possible,” it usually is not — and we would rather tell you that than sell you something.
The gap analysis
Before looking at any product, do this arithmetic. It takes ten minutes and it decides everything that follows.
Step one: total your genuinely essential monthly expenses. What you would still have to pay in a bad year: housing costs including taxes and insurance, utilities, food, transport, insurance premiums, and out-of-pocket healthcare. Not travel, not gifts, not hobbies — those sit above the floor.
Step two: total your guaranteed monthly income. Social Security at your intended claiming age, any pension, any existing annuity income.
Step three: subtract. The difference is your income gap.
Our retirement income gap calculator does this and expresses the result as a withdrawal rate against your portfolio.
What the answer means:
- No gap. Your guaranteed income covers your essentials. Your portfolio is funding discretionary spending rather than keeping the lights on, and a poor run of markets is uncomfortable rather than dangerous. On these numbers there is no case for buying guaranteed income, and we will say so.
- A modest gap your portfolio covers at a low withdrawal rate. A portfolio handles this perfectly well for most households. An annuity is optional, and the honest reason to buy one is that you would prefer the certainty — which is a legitimate reason.
- A large gap requiring a high withdrawal rate. Now sequence risk deserves genuine attention, and covering some of the gap with guaranteed income is a defensible structural decision rather than a product sale.
The gap is also the size of any annuity you buy. Not a percentage of your portfolio, not a round number someone suggested — the gap.
The four types worth knowing
1. Multi-year guaranteed annuity (MYGA)
The simplest product in the category. You deposit a lump sum, the insurer guarantees a fixed interest rate for a fixed term — commonly three to ten years — and at the end you take the money, renew, or roll it into another contract.
Functionally it is a certificate of deposit issued by an insurance company rather than a bank, with two differences: the guarantee is backed by the insurer rather than federal deposit insurance, and growth is tax-deferred in a non-qualified account rather than taxed annually.
Genuinely good for: money with a known horizon that you want safe and predictable — a bridge to a Social Security claiming date, a planned purchase, a conservative sleeve of a portfolio.
Watch: the surrender period, which usually matches the rate term, and what happens at the end. Some contracts auto-renew at a much lower rate unless you act within a short window.
2. Fixed indexed annuity (FIA)
Principal protection with index-linked growth potential. Your account value is credited based on the movement of a market index, subject to a floor — almost always zero percent — and a cap or participation rate limiting the credit.
| Index return | Credited with a 9% cap | Credited at 60% participation |
|---|---|---|
| +22% | +9% | +13.2% |
| +10% | +9% | +6% |
| +4% | +4% | +2.4% |
| −15% | 0% | 0% |
| 0% | 0% | 0% |
You are not invested in the index and you do not receive its dividends. The comparison is not “FIA versus owning the index” — it is “FIA versus a fixed rate, with more variability and a zero floor.”
Genuinely good for: money you want protected from index losses with more upside than a fixed rate, over a long horizon, where you do not need liquidity.
Watch: caps and participation rates are declared by the insurer and can be changed for future segments. Ask what the guaranteed minimum is, not just today’s rate.
3. Single premium immediate annuity (SPIA)
You hand over a lump sum and income starts within a year, for a fixed period or for life. It is the oldest and simplest form of the product, and generally the most efficient way to buy income per dollar of premium, because there is no accumulation phase and no rider fee.
Options include life only, life with a period certain, joint life for a couple, and cash refund arrangements that return any unpaid balance to a beneficiary. Each protection you add reduces the monthly payment — that is the trade, and it is priced fairly.
Genuinely good for: filling an income gap starting now, simply and cheaply.
Watch: annuitising is generally irreversible. The money is gone in exchange for the income stream. That is the point of the product, and it is a decision that deserves real time.
4. Deferred income annuity (DIA)
You pay now and income begins years later — often ten or twenty. Because the insurer has both time to invest and mortality credits working in its favour, the eventual income per dollar is substantially higher than a SPIA bought at the same time.
This is longevity insurance in its purest form: a relatively small premium at 65 producing meaningful income from 80 or 85 onward, which lets the rest of your plan run on a defined horizon rather than an unknown one.
Genuinely good for: insuring against living a very long time, cheaply.
Watch: you may not live to collect. Contracts with return-of-premium features address that and cost more.
The contract terms that decide everything
Product type is the easy part. The contract terms are where value is won or lost.
The surrender schedule
A declining penalty on withdrawals above the free amount, during a defined period. A seven-year schedule might run 7 percent in year one, 6 in year two, and so on to zero in year eight.
It exists because the insurer invests your premium on a matching long horizon and needs to know the money will stay. It is not a trick, but it is a genuine constraint: only commit money you will not need during the surrender period.
The free withdrawal provision
Most contracts allow you to withdraw a percentage of the account value each year without penalty — commonly 10 percent. Some allow more in the first year, some less. Some allow only interest earned. Check the specific provision.
The market value adjustment
An additional adjustment on early withdrawals, up or down, reflecting interest rate movement since issue. If rates rose, an early withdrawal is worth less; if they fell, more. It applies on top of the surrender charge in many contracts.
The income rider, and the number that misleads people
An income rider guarantees a lifetime withdrawal amount without annuitising — you keep the account value and take guaranteed income from it.
It carries an annual fee, typically deducted from the account value, and it is charged whether or not you ever turn the income on.
And here is the misunderstanding that dominates the category:
Benefit base is not account value
A contract advertising a “7 percent roll-up” is not paying you 7 percent.
It is growing a hypothetical benefit base used solely to calculate a future income payment. Your actual account value — the money you could withdraw, or leave to a beneficiary — grows at the crediting rate, which is a different and usually much smaller number.
Both figures appear on the statement. People see the larger one, believe they have that much money, and are shocked when they try to withdraw it.
Ask directly: “Which of these numbers can I take out in cash?” The answer is always the account value.
Income riders are not bad products. They solve a real problem for people who want lifetime income but cannot bear to hand over the lump sum irrevocably. But the roll-up rate is a marketing number, and any presentation that leans on it without explaining the distinction should make you slow down.
What to check before signing anything
- The surrender schedule — how many years, what percentage each year
- The free withdrawal provision — how much, from when
- Whether a market value adjustment applies
- The rider fee, charged annually against the account value
- The distinction between account value and benefit base
- The guaranteed minimum cap or participation rate, not just the current one
- The insurer’s financial strength ratings from the independent agencies
- What happens at death — to the account value, and to any income stream
- Whether the contract is qualified or non-qualified, and the tax consequence
Taxes
Growth inside an annuity is tax-deferred. When you withdraw from a non-qualified annuity, gains come out first under last-in-first-out treatment and are taxed as ordinary income — not at capital gains rates. Withdrawals before age 59½ can incur an additional 10 percent federal penalty.
Two further points worth knowing:
Annuities inside an IRA gain no additional tax deferral. The IRA is already tax-deferred. If an annuity belongs in an IRA, it is for the guarantee, not the tax treatment — and any presentation implying otherwise is wrong.
Annuities do not receive a step-up in basis at death the way many taxable investments do. Beneficiaries inherit the tax liability on the gain. If legacy is a priority, that matters.
Annuitised income is split between a tax-free return of principal and a taxable gain portion, using an exclusion ratio.
We are insurance brokers, not tax advisers. We will flag these points and tell you when the conversation belongs with your accountant.
The criticisms, addressed honestly
“Annuities have high fees.”
Some do. A fixed indexed annuity with an income rider and multiple add-ons can carry meaningful annual costs. A MYGA or a SPIA carries essentially no explicit ongoing fee — the insurer’s margin is built into the rate or the payout. Blanket statements about fees in this category are usually about one product type being generalised to all of them.
“You can do better in the market.”
Over long periods, probably — in expectation. That is not what an annuity is for. You are buying the removal of specific risks, and the price of removing risk is expected return. Comparing an annuity to an equity portfolio is comparing insurance to an investment.
“Commissions create bias.”
This one is fair and worth naming plainly. Annuity commissions are paid by the insurer and built into the product economics, and they vary between product types — generally higher on indexed products with riders and lower on MYGAs and SPIAs. That creates a genuine incentive to steer, and anyone who tells you otherwise is not being straight with you.
The protections are: ask about the structure, ask why this product rather than a simpler one, and use someone who will recommend the lower-commission product when it fits better. We will tell you the structure of anything we recommend.
“Once you annuitise, the money is gone.”
Correct, for SPIAs and DIAs. That is the product working as designed — you exchanged a lump sum for a guaranteed income stream. It is why the decision deserves real time, and why the amount should be sized to the gap and no larger.
Sizing it: a worked framing
Consider a couple with $2,400 and $1,500 of monthly Social Security — $3,900 guaranteed. Their essential expenses total $5,200 a month.
Their gap is $1,300 a month, or $15,600 a year.
With a $750,000 portfolio, that gap alone represents a withdrawal rate of about 2.1 percent — comfortably sustainable. This household probably does not need an annuity for the essentials, and if they buy one it should be because they want the certainty, not because they need it.
Change one variable. Same expenses, same guaranteed income, but a $300,000 portfolio. Now the gap is a 5.2 percent withdrawal rate before any discretionary spending — a level at which a poor opening decade is genuinely dangerous. For this household, covering part of the gap with guaranteed income is a structural decision that materially improves the plan.
Same gap. Completely different answer. The product does not decide; the arithmetic does.
What we will not do
- Recommend putting all or most of your savings into an annuity
- Present a benefit-base roll-up rate as though it were an account value return
- Skip past the surrender schedule because it is in the second half of the brochure
- Sell an annuity inside an IRA for tax deferral it does not add
- Give you tax or investment advice — we are licensed for insurance, and we stay there
If you already work with a financial adviser or an accountant, we would rather coordinate with them than around them. The best outcomes we see come from the insurance piece being sized deliberately and the rest of the plan being left alone.
What about long-term care?
Worth raising here because it is the exposure most likely to break a retirement plan, and Medicare does not cover custodial care.
Some annuities and some life policies include long-term care or chronic illness riders, and hybrid products exist that combine a death benefit with a long-term care pool. Whether a rider, a hybrid or a standalone policy fits depends on your health, your assets and your family history.
It is a separate conversation and it works far better with lead time than in a crisis. If it is on your mind, raise it.
What to do next
- Run the numbers with the retirement income gap calculator
- Read the detail on annuities
- If you want the full analysis, retirement income planning is what we do and it costs nothing
- Or just call us on (800) 657-4213
A meaningful share of these conversations end with us saying no product is needed. That is a perfectly good outcome, and it is why we can afford to run the analysis for free.
Frequently asked questions
Are annuities a good investment?
Annuities are not primarily investments — they are contracts that transfer specific risks to an insurance company, chiefly longevity risk and sequence-of-returns risk. Judged as investments they usually look mediocre. Judged as insurance against outliving your money, they do something no portfolio can do on its own.
How much of my savings should go into an annuity?
As a general rule, no more than the amount needed to close the gap between your essential monthly expenses and your guaranteed income from Social Security and any pension — and often less. Annuities trade liquidity and growth for certainty, which is a sensible trade only for the money doing the certainty job.
What is a surrender charge?
A declining penalty applied if you withdraw more than the free withdrawal amount during the surrender period, commonly five to ten years. It exists because the insurer invests your premium on a matching long horizon. Only commit money you will not need during that period.
What is an income rider roll-up rate?
A guaranteed growth rate applied to a hypothetical benefit base used solely to calculate future income payments — not to your actual account value. A contract advertising a 7 percent roll-up is not paying you 7 percent on withdrawable money. Confusing the two is the most common misunderstanding in the category.
Are annuities safe?
Annuity guarantees are backed by the financial strength of the issuing insurance company, not by any federal agency. State guaranty associations provide a backstop up to state-specific limits. Carrier ratings and contract terms are both genuine parts of the decision.