In the video above, you heard Financial Enhancement Group advisors discuss one of the most frequently misunderstood tools in retirement planning: annuities.
In the discussion, advisors Aaron Rheaume, CKA®, Director of Financial Planning, and Grant Thompson, CFP®, CKA® break down the basics of how annuities work, their potential advantages, and where they may or may not fit into a financial plan.
In this article, we’ll expand on that conversation by exploring:
- What an annuity actually is
- How annuities work
- The different types available
- The pros and cons retirees should understand
- Strategic planning considerations before purchasing one
The goal is not to promote or discourage annuities, but to help you understand when they may play a role in a retirement strategy.
What Is an Annuity?
An annuity is a financial contract between you and an insurance company designed to provide income, typically during retirement.
In its simplest form, you provide a lump sum or series of payments to an insurance company. In return, the company agrees to provide future income payments, either immediately or at a later date.
As Grant Thompson, CFP®, CKA®, explains:
“Simply put, an annuity is when you take a sum of money and place it into an insurance product. You're transferring the risk to the insurance company for a guaranteed payout or a monthly income stream.”
Many retirees consider annuities because they can convert savings into predictable income, which can help support spending during retirement.
However, annuities are not one-size-fits-all products. Their structure, fees, and guarantees vary widely.
How Annuities Work
Although annuity contracts differ, most follow a similar framework involving two main phases.
Accumulation Phase
During this stage, you contribute money to the annuity.
This may involve:
- A single lump sum payment
- A series of contributions over time
- Rolling over funds from a retirement account such as an IRA
The money grows according to the structure of the annuity contract.
Depending on the type of annuity, growth may be:
- Fixed
- Market-linked
- Investment-based
Income Phase
At some point, the annuity begins making income payments.
These payments may:
- Start immediately
- Begin at a future retirement date
- Continue for a fixed period
- Last for the rest of your life
The purpose of this structure is to convert savings into reliable income during retirement.
Why Some Retirees Consider Annuities
One of the biggest concerns retirees face is running out of money during retirement.
Unlike a traditional investment portfolio, certain annuities can provide income that continues even if markets fluctuate.
As Grant explains:
“Some of the pros of annuities are that you’re transferring risk to the insurance company to give you a monthly income stream.”
This transfer of risk is often the central appeal of annuities.
Instead of relying entirely on investment performance, retirees can create a predictable income source alongside Social Security and other assets.
Common Types of Annuities
There are many annuity variations, but most fall into four main categories.
Fixed Annuities
Fixed annuities offer a guaranteed interest rate and predictable growth.
Key characteristics include:
-
Stable returns
-
Low exposure to market risk
-
Predictable income payments
They function somewhat like a certificate of deposit issued by an insurance company, although with different tax rules.
Variable Annuities
Variable annuities allow funds to be invested in market-based subaccounts, similar to mutual funds, which are subject to market loss and/or gain depending on the product.
Returns depend on market performance.
Features may include:
-
Higher potential growth
-
Greater investment risk
-
Optional riders for guaranteed income
Aaron Rheaume noted during the conversation:
“There’s a lot of variables to annuities… pun intended.”
These products can be more complex and often include additional fees.
Indexed Annuities
Indexed annuities link returns to a market index, such as the S&P 500.
However, they typically include mechanisms like:
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Caps on gains
-
Participation rates
-
Minimum guaranteed returns
Grant referenced this concept when discussing performance floors:
“A lot of them will have floors… they might say you can’t earn less than three percent in the account.”
These structures aim to balance growth potential with downside protection.
Immediate vs Deferred Annuities
Annuities can also be categorized by when income payments begin.
Immediate Annuities
Income begins shortly after the initial investment.
These are often used by retirees who want income right away.
Deferred Annuities
Income begins later, allowing time for the investment to grow before withdrawals begin.
These are often used as long-term retirement planning tools.
Pros of Annuities
Annuities can offer several benefits in the right circumstances.
Guaranteed Income
Many annuities provide income that lasts for life.
This can help retirees manage longevity risk, or the possibility of outliving their savings.
Risk Transfer
The insurance company assumes certain financial risks.
For retirees who prefer predictable income, this can provide peace of mind and stability.
Downside Protection
Some annuities offer minimum return guarantees, helping reduce exposure to significant market downturns.
Tax-Deferred Growth
Like traditional retirement accounts, annuity earnings typically grow tax-deferred until withdrawals begin.
Cons of Annuities
Despite their potential benefits, annuities also have drawbacks.
Complexity
Annuity contracts can be difficult to evaluate.
Grant highlighted this concern:
“They can oftentimes be expensive, and you don’t really know that upfront. It’s really hard to tell what things cost.”
Fees and riders can make it challenging to compare products.
Limited Liquidity
Many annuities include surrender periods, which restrict access to funds.
Aaron explained:
“A lot of annuity contracts will have a surrender charge if you need liquidity in a short period of time.”
These penalties can last five to ten years or longer.
Lower Growth Potential
Some annuities limit upside returns in exchange for protection.
For investors seeking long-term growth, other investment vehicles may offer greater potential.
Fees
Depending on the structure, annuities may include:
- Administrative fees
- Mortality and expense charges
- Rider costs
- Investment management fees
These costs can significantly affect long-term performance.
Strategic Planning Considerations
Annuities should never be evaluated in isolation. They interact with many aspects of a retirement plan.
Below are several important planning considerations.
Income Planning and Longevity Risk
One of the primary uses of annuities is to create predictable retirement income.
Why this matters:
A guaranteed income source can reduce pressure on investment portfolios during market downturns.
Tax Bracket Management
Withdrawals from annuities are generally taxed as ordinary income.
Why this matters:
Large annuity distributions could push retirees into higher tax brackets if not planned carefully.
Social Security Taxation
Additional retirement income sources may affect how much of your Social Security benefits become taxable.
Why this matters:
Improper coordination between income sources could increase total taxes during retirement.
Medicare IRMAA Impacts
Higher income can trigger Income-Related Monthly Adjustment Amount (IRMAA) surcharges on Medicare premiums.
Why this matters:
Additional annuity income may increase Medicare costs in certain years. There is a two year lookback so what you do today will not be seen until two years from now.
Liquidity Needs
Many annuity contracts restrict withdrawals during the surrender period.
Why this matters:
If unexpected expenses arise, accessing funds could result in penalties.
Investment Sequencing Risk
Market downturns early in retirement can permanently damage portfolio sustainability.
Why this matters:
In some cases, annuities can provide stable income that reduces withdrawals from investment accounts during volatile periods.
What This Means for You
The biggest takeaway from the discussion is that annuities are tools within a broader retirement strategy, not standalone solutions.
For some retirees, they can provide a predictable income stream that reduces financial uncertainty. For others, the costs, complexity, or reduced liquidity may outweigh the benefits.
The key question isn’t simply whether annuities are “good” or “bad.” It’s whether a particular annuity fits within the larger structure of your financial plan.
Factors that influence this decision often include:
- How much guaranteed income you already have (such as Social Security or pensions)
- Your tolerance for market volatility
- Your need for liquidity and flexibility
- Your tax situation in retirement
In other words, the role of an annuity depends heavily on the bigger picture of your retirement strategy.
Frequently Asked Questions About Annuities
What is the main purpose of an annuity?
An annuity is designed to convert savings into predictable retirement income, often guaranteed for life.
Are annuities safe?
Annuities are backed by insurance companies rather than banks. Their safety depends on the financial strength of the issuing insurer.
Can annuities lose money?
Some annuities offer guaranteed minimum returns, while others such as variable annuities can lose value depending on market performance.
What is the difference between an annuity and an IRA?
An IRA is a tax-advantaged retirement account, while an annuity is an insurance contract. An annuity can sometimes be held inside an IRA.
When do annuity payments start?
Payments may begin immediately or at a future date depending on whether the annuity is immediate or deferred.
Are annuities taxable?
Yes. Withdrawals from non-Roth annuities are generally taxed as ordinary income.
What is a surrender charge?
A surrender charge is a penalty applied when withdrawing funds during the annuity’s restricted period.
Are annuities good for retirement income?
They can be useful for generating predictable income, but they should be evaluated within the context of a complete retirement plan.
Can I withdraw money early from an annuity?
Most contracts allow limited withdrawals, but larger withdrawals during the surrender period may trigger penalties.
Do annuities pass to heirs?
Some annuities include death benefit provisions, allowing remaining funds to pass to beneficiaries.
Final Thoughts
Annuities are among the most debated tools in retirement planning. In the right situation, they can provide stable income and risk protection. In the wrong situation, they can add unnecessary complexity and cost.
That’s why decisions about annuities should always be made within the context of a full financial plan.
If you're approaching retirement or evaluating income strategies, a short fiduciary conversation can help clarify whether an annuity belongs in your plan — before making a decision that may be difficult to reverse.
If you’d like guidance, consider speaking with a fiduciary advisor at Financial Enhancement Group to review your retirement income strategy.
Financial Enhancement Group is an SEC Registered Investment Advisor.
