Ultimate Guide to Understanding Annuities

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Updated on Monday, September 9, 2019

Annuities are a popular way for Americans to build their savings and then generate income after they retire. Annuities are a massive market: According to data from LIMRA, in 2018, total annuity sales were over $233 billion and the total amount of money held in deferred annuities was over $3 trillion.

But despite their popularity, annuities also have their fairshare of critics, and there is no shortage of opinion pieces online calling them a bad investment. We asked David Haas, a Certified Financial Planner and president of Cereus Financial Advisors, whether annuities deserved this criticism.

“Annuities have a bad reputation because they are sold for the wrong reasons and some of them come with significant fees or are designed not to perform the way investors expect (and were promised),” he said. “The insurance industry also has used very poor sales practices in the past to earn this reputation.”

With that in mind, Haas still does think annuities have value. “Annuities can be useful tools in your financial strategy as long as you understand what they can do and what they can’t.”

To help you understand annuities, we’ve put together this guide to cover the key elements of saving through an annuity and spoke with multiple financial experts to get their advice.

How do annuities work?

Before we get into the specific types of annuities, let’s review the basics of how they work. First off, what are annuities? Annuities are investment contracts typically offered by insurance companies. They are not deposit accounts, and as a result are not covered by federal deposit insurance. This can make them a little riskier than deposit accounts like certificates of deposit, according to Ken Tumin, founder of LendingTree-owned DepositAccounts.com.

“CDs typically have federal deposit insurance up to coverage limits. Annuities do not have federal insurance guarantees,” he said. “Annuities do have state guarantees, but these are not as automatic as federal deposit insurance.”

However, annuities do have some advantages over deposit accounts which are split over the two phases of the contract: accumulation and distribution.

Annuity accumulation phase

To open an annuity, you’ll need to deposit money with the company selling the contract. This can be a single lump sum, multiple payments over time, or a transfer of money from another retirement/insurance account. If you aren’t ready to start spending down your savings, you can keep all your money in the account so it grows for the future. This is known as the accumulation phase.

Your money will grow over time, using the investment strategy picked by the type of annuity: fixed, variable or index. See the next section for more specifics on how these strategies work.

So long as your money stays in the annuity, you will not owe income tax on your investment gains. Tumin pointed out that this is one of the benefits of annuities versus CDs. “Earnings from annuities are tax deferred. CDs are not, unless they’re in an IRA.”

Once you are ready to spend down your savings, you ask the company to switch your contract to the distribution phase.

Annuity distribution phase

The distribution phase is when the annuity starts paying you back your contributions. You have a few different options. First, you could spread the payments over a set amount of time, like monthly payments over 10 years or 20 years. The company will tell you how much you’d receive per month based on your balance, age and expected investment return.

Another option is to set up your annuity so that it makes guaranteed payments over your entire life. The company is responsible for making sure it can keep up with all those payments, no matter how long you live. This is another key benefit, according to Tumin. “Unlike CDs, income annuities provide longevity insurance. Payments from an annuity can last until one dies. There’s no risk of your savings running out.” Finally, you can take some or all money out as a lump sum.

Your payouts are taxable income, but the amount that’s taxed depends on how you purchased the annuity. If you bought the annuity using pre-tax money, like through a 401k, then all your annuity income counts as taxable income. If you bought your annuity using regular, after-tax funds, then you only owe tax on your annuity earnings. You get your deposit back tax-free.

Additionally, if you take out a lump sum withdrawal of your earnings and/or pre-tax contributions before you turn 59½, the IRS will charge a 10% early withdrawal penalty on that amount. This is because annuities are supposed to be used to save for retirement. The penalty does not apply when you withdraw your after-tax contributions, though when you make a withdrawal, the IRS assumes your earnings are coming out first. If you schedule payments over time for at least five years or the rest of your life, you can also receive money from your annuity before you turn 59½ without the penalty.

Are there fees with annuities?

Annuities charge a number of fees. First, the company may charge several annual fees to cover the costs of running the annuity. These can be labeled as administrative fees, mortality fees, distribution fees and/or general fees. Altogether, the company may deduct between 0.3% to 2% from your annuity balance each year for these fees.

The investments in your annuity may also charge an annual fee and deduct it from your balance. Typical investment expense ratios range from 0.6% to 3% a year. These are similar fees you’d owe for making the investment outside of an annuity. Once again, the company will deduct the fee from your balance.

When you buy your annuity, you have the option to add extra benefits to your contract known as riders. For example, you can set up your annuity payments to grow based on inflation or to have a contract that pays your heirs a death benefit after you pass away. You would need to pay an extra fee each year for setting up these riders.

Finally, annuities are meant to be long-term investments and may have a fee if you cancel or withdraw your money early, known as a surrender charge. These can be quite expensive and go as high as 7% of your account balance. As time goes by, the surrender charge will decrease in size before ending completely after seven to 10 years, when you can take your money out penalty-free.

Are annuities liquid?

Annuities are not liquid investments because of the surrender charge. If you want to withdraw some or all of your balance, especially during the first few years after setting up your contract, you can expect to pay a steep penalty to cash out a lump sum.

Some companies offer a little extra flexibility with taking money out penalty-free. For example, they may allow you to withdraw up to 10% of your balance without the surrender charge. But even in this case, annuities are nowhere as liquid as a bank account or a regular brokerage account, where you can cash out your money without owing a penalty.

Three main types of annuity: Fixed, indexed and variable

In terms of investment strategies, there are three main categories of annuities: Fixed, indexed and variable.


Fixed annuity

Indexed annuity

Variable annuity

Rate of return

3% to 5% per year

Stock market returns with limits to your potential loss and gain. Usually comes with some small guaranteed return.

Based on your investments

Typical fees

Administrative expenses and surrender charges, but no investment management fees

Administrative expenses, surrender charges and investment management fees

Administrative expenses, surrender charges and investment management fees


Only by state insurance commissioners

By the SEC and state insurance commissioners

Usually only by state insurance commissioners. In some cases, may be regulated by the SEC as well.


Gains are tax deferred. Payouts are 100% taxed when the annuity was purchased with pre-tax money. Only gains are taxable if the annuity was purchased with after-tax money.

Gains are tax deferred. Payouts are 100% taxed when the annuity was purchased with pre-tax money. Only gains are taxable if the annuity was purchased with after-tax money.

Gains are tax deferred. Payouts are 100% taxed when the annuity was purchased with pre-tax money. Only gains are taxable if the annuity was purchased with after-tax money.

Fixed annuities

Fixed annuities pay a set return on your money. For the first few years, the company may guarantee a minimum return and after that, what you earn could change depending on market interest rates. With a fixed annuity, you cannot lose money because of your investment. It’s similar to putting your savings into a CD.

When it comes to generating retirement income, Haas noted that a fixed annuity can be more predictable. “Fixed annuities provide a simple guaranteed income stream, which is fixed for the payout period selected,” Haas said.

Variable annuities

With a variable annuity, you put your money into market-based investments, typically mutual funds with combination of stocks, bonds and money market accounts. The amount you earn will then depend on the market, so this can change dramatically year after year and your account balance can fall during market downturns.

Depending on your return, this can impact your monthly income during the annuity payout period. Haas pointed out that there are ways to get at least some stability to your payments though. “Variable annuities can attach guarantees for the income stream but come with increased expenses and restrictions on the investments,” he said.

Indexed annuities

Indexed annuities pay out a return that follows the stock market, with some additional safeguards and limits. When you sign up, you pick a market index that you want to track, like the S&P 500. Indexed annuities typically guarantee a minimum annual return — even if the market ends the year in the red, your funds still grow, usually around 2%.

In exchange, these annuities set restrictions on how much you can earn during good years. The annuity may cap your maximum possible return like you can earn no more than 6% per year. Another possibility is the indexed annuity only allows you to earn a portion of the total gains. For example, you keep 70% of your total investment earnings while the company keeps the rest. As a result, indexed annuities are safer than variable annuities but their upside is not as high.

Deferred annuities vs. immediate annuities

The insurance industry also classifies annuities as deferred versus immediate. Like the name implies, an immediate annuity starts paying you money back right away. There’s no accumulation period so the payout period begins right after you purchase the contract. They are also known as income annuities because they immediately turn your savings into a series of future income payments.

Deferred annuities do not start paying out right away. Instead, they have an accumulation period to build your savings for some point in the future.

Brandon Renfro, a financial planner and professor of finance at East Texas Baptist University, thinks immediate/income annuities can be a good choice for retirees. “Income annuities are simple and easy to understand. You exchange a lump sum of money for a guaranteed payment stream.”

Deferred annuities on the other hand may be a better fit before retirement, when you don’t need extra income and your goal is to build your nest egg so you have a larger future payout.

Cost-of-living adjustments for annuities

Some companies allow you to add an extra benefit to your contract called a cost-of-living adjustment (COLA) rider. When you buy a contract with this rider, you pick a percentage for how much your annuity payments will increase each year. If you selected 3%, your monthly payments will grow by 3% every year.

You could also buy a CPI-rider which adjusts your monthly payment based on the inflation rate. When inflation is high, your income will go up and when there is no inflation, your payments will stay the same.

With these riders, you protect your retirement income against rising prices from inflation. Over the past decade, inflation has been about 2%, according to the Bureau of Labor Statistics. If your payments stayed the same throughout retirement, you would see your purchasing power fall by the inflation rate over time.

Renfro warned that the cost of this feature can be prohibitive. “Some annuity payments will automatically include COLA provisions, but this is very rare,” he said. “Chances are, the price you’ll pay for an annuity with an inflation-adjusted payment will be considerably higher.”

The way this works is that for the same deposit, you’ll start out at a lower monthly income for an annuity with a COLA or inflation rider versus a regular annuity. In exchange, your payments will increase over time while the regular annuity will always pay out the same amount. You need to decide whether the inflation protection is worth the lower starting income.

Who insures and regulates annuities?

All annuities are regulated at the state level through the insurance commissioner’s office. Insurance companies and their representatives must register with the insurance commissioner in every state where they want to sell these contracts. The insurance commissioner will verify that the company is financially stable enough to meet its obligations and that it is following the rules for managing these plans. They also collect and investigate complaints against annuities.

In addition, the federal government regulates variable annuities through the SEC as these agencies oversee any investments based on the stock market. The federal government does not oversee fixed annuities and it rarely oversees indexed annuities.

Annuity bankruptcy

Despite these regulations, there is always the chance that your insurance company could go bankrupt and may not be able to pay you back according to the terms in your annuity contract. Annuities are not deposit accounts and not covered by the FDIC, so you are not guaranteed to get your money back.

Every state has its own insurance guaranty fund for when companies go bankrupt, but there’s a limit to how much they will pay out, typically $250,000 for annuities. If you are owed more than that, you can file a legal claim against the insurance company and try to collect as it liquidates its assets through bankruptcy, but there is no guarantee you’ll get the rest of your money. It can also take time to get your money through the court process.

In the end, while annuities are partially insured against, your best defense is to avoid getting into this situation in the first place. As part of your research, you should also check the credit rating of any insurance company through agencies like Standard & Poor’s or Moody’s. Consider only signing up with companies that have a strong rating to make sure they can safely pay you back.

Are annuities right for you?

To figure out whether an annuity is the right fit for you, you need to closely understand the rules and different types available. But figuring this out isn’t always easy for non-financial experts. For help with this decision, consider reaching out to a financial advisor.

As you interview candidates, you may want to ask whether the advisor gets a commission from selling the annuity. A common theme throughout our interviews was that annuities have a bad reputation because salespeople can get a large commission from selling them, so some bad actors pushed contracts that were not a great match for their clients. If you hire a fee-only advisor who is paid for their time and advice rather than a commission for selling products, that can help you avoid a conflict of interest.

In the end, annuities remain one of the few options to set up guaranteed retirement income that lasts your entire life which is why even with their potential drawbacks they are worth considering. By using the information in this guide and working with a trusted advisor, you can decide what role if any annuities will play in your financial plan.