Annuities
What Is an Annuity?
An annuity is a financial contract issued by an insurance company designed to help individuals accumulate money, protect principal, and/or generate guaranteed income, typically for retirement. At its core, an annuity transfers certain financial risks—such as longevity risk and market volatility—from the individual to the insurance company.
Annuities are commonly used by individuals who want certainty, predictable income, and risk management, especially during or approaching retirement.
How Annuities Work
Annuities operate in two main phases:
1. Accumulation Phase
During this phase, money is contributed to the annuity—either as a lump sum or through a series of payments. The funds grow on a tax-deferred basis, meaning taxes on gains are not due until money is withdrawn.
Growth depends on the type of annuity selected:
Fixed interest
Market-linked interest
Investment-based performance
2. Distribution (Income) Phase
In this phase, the annuity begins paying income to the owner. Payments may be:
For a set period (e.g., 10 or 20 years)
For life
Jointly for spouses
The defining feature of annuities is the ability to provide guaranteed income that cannot be outlived, subject to contract terms.
Primary Types of Annuities
1. Fixed Annuities
Fixed annuities offer a guaranteed rate of return for a specified period.
Key characteristics:
Stable and predictable growth
No exposure to market loss
Tax-deferred accumulation
These are often used as conservative accumulation tools or alternatives to bonds or CDs, especially when principal protection is a priority.
2. Deferred Income Annuities
Deferred income annuities allow income payments to start at a future date, often years later.
Key characteristics:
Income grows during deferral
Higher future income compared to immediate annuities
Designed to address longevity risk
These are sometimes referred to as longevity insurance.
3. Variable Annuities
Variable annuities allow funds to be invested in sub-accounts similar to mutual funds.
Key characteristics:
Market-based growth potential
Exposure to market risk
Optional guarantees through riders (such as lifetime income)
These products are typically used by individuals with a higher risk tolerance and require appropriate licensing to sell.
5. Fixed Indexed Annuities (FIA)
Fixed indexed annuities credit interest based on the performance of an external market index (such as the S&P 500), without directly investing in the market.
Key characteristics:
Upside potential linked to index performance
Protection from market losses
Returns subject to caps, spreads, or participation rates
FIAs are commonly used by individuals who want market-linked growth with downside protection, making them popular for pre-retirees and retirees seeking balance between growth and safety.
4. Immediate Annuities
Immediate annuities convert a lump sum into income payments that begin shortly after purchase.
Key characteristics:
Income starts almost immediately
Payments may be guaranteed for life or a fixed period
Little to no liquidity once income begins
They are often used to create a retirement income floor, covering essential living expenses.
1. Guaranteed Lifetime Income
One of the most important benefits of annuities is the ability to provide income for life, regardless of how long the individual lives.
3. Tax-Deferred Growth
Earnings grow tax-deferred, allowing compounding to work more efficiently over time.
2. Principal Protection
Certain annuity types protect the original investment from market losses, offering peace of mind during volatile periods.
4. Customization Through Riders
Optional features may include:
Lifetime income riders
Death benefit riders
Inflation-adjusted income
Enhanced liquidity provisions
Key Benefits of Annuities
These allow annuities to be tailored to specific retirement goals.
Things to Note
Common Trade-Offs and Considerations
While annuities offer guarantees, they also involve important considerations:
Liquidity limitations: Early withdrawals may trigger surrender charges.
Fees: Some annuities include fees, especially those with optional riders or investment components.
Return limitations: Products with guarantees often cap upside potential.
Tax treatment: Withdrawals are taxed as ordinary income, not capital gains.
Understanding these trade-offs is essential when determining suitability.
When Annuities Are Commonly Used
Annuities are often appropriate when individuals want:
Income certainty in retirement
Protection from market volatility
A predictable cash-flow foundation
Longevity risk management
Tax-deferred accumulation beyond qualified plans
They are typically not designed for short-term investing, but rather for long-term planning and income security.
Annuities in a Retirement Strategy
Annuities are most effective when integrated into a broader financial plan. They can complement:
Social Security
Pension income
Investment portfolios
Legacy and estate planning strategies
Used properly, annuities help shift a retirement plan from a return-focused mindset to an income-focused strategy, prioritizing stability, predictability, and peace of mind.
