An annuity is a contract with an insurance company that can convert a lump sum into a stream of income, often for life. Retirees use them to create a personal pension that cannot be outlived, addressing the fear of running out of money. Annuities come in many forms with very different costs and features, so it pays to understand the basic types.
Immediate versus deferred annuities
An immediate annuity, sometimes called a single premium immediate annuity, starts paying income right away in exchange for a lump sum. A deferred annuity instead grows for years before you turn it into income, which is useful for accumulating money tax-deferred first. Deferred annuities can later be annuitized into a stream of payments or left to grow. The choice depends on whether you need income now or are still building toward retirement.
Fixed, variable, and indexed types
A fixed annuity pays a guaranteed interest rate and predictable income, much like a bank CD but from an insurer. A variable annuity invests in subaccounts resembling mutual funds, so your value and income rise and fall with the markets, usually with higher fees. An indexed annuity ties growth to a market index with caps and floors, offering some upside with downside protection. Each type trades predictability against growth potential in a different way.
How lifetime income and mortality credits work
When you annuitize, the insurer pools your money with many other buyers and pays income for as long as you live. Those who die earlier effectively subsidize those who live longer, a benefit known as mortality credits that no ordinary investment provides. This pooling is why an annuity can pay more than you could safely withdraw on your own from the same sum. The trade-off is that you generally give up access to the lump sum in exchange for the guaranteed stream.
Costs, guarantees, and cautions
Annuities can carry surrender charges that penalize early withdrawals, along with fees and riders that add cost and complexity. Guarantees are only as strong as the issuing insurer, though state guaranty associations provide limited backup coverage. Inflation can erode a fixed payment's purchasing power unless you buy a cost-of-living rider. Because products vary widely, comparing quotes and reading the contract carefully is essential before committing.
A 65-year-old puts 200,000 dollars into an immediate annuity and receives roughly 1,250 dollars a month for life, an annual payout near 7.5 percent that includes both return of principal and mortality credits. The exact amount depends on prevailing interest rates, the insurer, and any survivor or inflation features chosen.
Key takeaways
- Annuities are insurance contracts that can turn a lump sum into guaranteed income.
- Immediate annuities pay now; deferred annuities grow first, then can be annuitized.
- Fixed, variable, and indexed types trade predictability against growth potential.
- Mortality credits let annuities pay more than self-managed withdrawals, but you give up the lump sum.
Common mistakes
- Buying a complex variable annuity without understanding its layered fees.
- Locking up money you may need and getting hit with surrender charges.
- Choosing a fixed payout with no inflation protection for a decades-long retirement.
FAQ
Are annuities a good investment?
They are better viewed as insurance against outliving your money than as an investment, and they suit retirees who value guaranteed income over growth and liquidity.
What happens to my money if I die early?
With a basic life-only annuity, payments stop, but survivor or period-certain options can guarantee payments to a spouse or beneficiary for an added cost.