What an annuity actually is, and why the answer depends on your situation

An annuity is a contract with an insurance company: you give them a lump sum of money now, and they pay you a stream of income later — either for a set number of years or for the rest of your life. Whether that is a good move depends entirely on your age, how much money you have, what you need the money for, and what other income sources you already have. There is no universal answer.

The core trade-off is straightforward: you exchange the ability to access your money freely for the certainty of a regular paycheck. That certainty has real value if you are worried about outliving your savings. It has almost no value if you are young, have other income, or need flexibility. The cost of that certainty — in fees, in lost growth potential, and in money you cannot pass to your heirs — is substantial enough that many people should skip annuities entirely.

Key Takeaways

  • Annuities lock your money away in exchange for may provide income, so they work best for people over 70 who have already saved enough and worry about running out of money in retirement.
  • Most annuities charge 1 to 3 percent per year in fees, plus surrender charges if you need your money back early, which can wipe out years of gains.
  • A straightforward portfolio of low-cost index funds and bonds often produces better results than an annuity, especially if you are under 60 or have less than $500,000 to invest.
  • when ready annuities (where you start receiving payments right away) are simpler and cheaper than deferred annuities, which come with complex features and higher costs.
  • Before buying an annuity, compare the may provide income it would pay you against what you could earn by keeping your money in stocks and bonds.

The real cost: fees, surrender charges, and lost flexibility

An annuity is not free to own. Most charge between 1 and 3 percent per year in management fees, mortality and expense charges, and administrative costs. On top of that, if you need to withdraw money before the contract term ends — which could be 5, 10, or even 15 years — you pay a surrender charge that starts high and declines over time. In the first year, that charge might be 7 to 10 percent of what you withdraw. Even in year five, it might still be 3 to 5 percent.

Those fees add up fast. A $300,000 annuity charging 2 percent per year costs you $6,000 in year one alone. Over 20 years, that is $120,000 in fees — money that could have stayed in your account and grown. If you need to access $50,000 in year three and face a 5 percent surrender charge, you lose another $2,500 just to get your own money back.

Compare that to a straightforward portfolio of low-cost index funds, which might charge 0.05 to 0.20 percent per year. The difference compounds over decades. A $300,000 portfolio in index funds at 0.10 percent per year costs $300 in fees — not $6,000.

Who annuities actually help: late retirees with large savings

Annuities make the most sense for people in a narrow situation: you are 70 or older, you have already accumulated a large amount of money (typically $500,000 or more), you have other income sources (Social Security, a pension, rental income), and you are genuinely worried about outliving your savings. In that case, an when ready annuity — where you hand over a chunk of money and start receiving payments right away — can provide peace of mind that a stock portfolio cannot.

The reason is longevity risk. If you live to 95 and your portfolio runs out at 90, an annuity would have kept paying. That is a real problem for some people. But it is not a problem for most. The average 65-year-old has a life expectancy in the low 80s. Many people die before they exhaust a reasonable portfolio. For them, an annuity straightforward locks away money they could have left to their children or used for unexpected medical costs.

A common middle ground: use an when ready annuity to cover your essential monthly expenses (rent, utilities, food, insurance) with the income it generates, and keep the rest of your money in a diversified portfolio for flexibility and growth. That way you get certainty for what you truly need, without sacrificing access to everything else.

when ready annuities versus deferred annuities: complexity and cost

An when ready annuity is straightforward. You give the insurance company $200,000 today, and they send you $900 per month for life. You know exactly what you are getting. The fees are lower because there is less to manage. These are worth understanding if you are in the late-retiree category above.

A deferred annuity is the opposite. You give the insurance company money now, it sits there and supposedly grows, and you start taking payments years later. These come in multiple flavors — fixed, variable, indexed — each with different fee structures, guarantees, and complexity. Many include riders (add-ons) that promise to protect your principal, may provide a minimum return, or adjust for inflation. Each rider adds another layer of fees.

Deferred annuities are rarely worth the cost. The fees are higher, the terms are harder to understand, and by the time you start withdrawing, you have paid years of charges on money that may not have grown much. If you are not yet retired and want to save for retirement, a 401(k) or IRA with low-cost index funds will almost always outperform a deferred annuity.

What you could earn instead: comparing annuity payouts to market returns

Before you buy an annuity, do this calculation. Ask the insurance company what monthly income a $300,000 when ready annuity would pay you at your age. Let us say they quote you $1,200 per month. That is $14,400 per year, or 4.8 percent of your principal.

Now ask yourself: could I earn more than 4.8 percent per year by keeping that $300,000 in a diversified portfolio of stocks and bonds? Historically, a portfolio that is 60 percent stocks and 40 percent bonds has returned around 7 to 8 percent per year over long periods, minus fees. Even after paying 0.20 percent in fees, you are looking at 6.8 to 7.8 percent. That is higher than the annuity payout.

The annuity company is betting you will not live long enough to collect more than $300,000 in total payments. If you live into your 90s, they lose that bet and you win. If you die at 80, they win and your heirs get nothing. That is the trade-off. Run the numbers for your own age and health, and decide whether the certainty is worth the cost.

Red flags: variable annuities and complex riders

A variable annuity is an annuity where your money is invested in mutual funds, and your payout depends on how those funds perform. This defeats the entire purpose of buying an annuity in the first place — you wanted certainty, not market risk. Yet variable annuities often come with high fees (2 to 3 percent per year) and complex riders that promise to protect you if the market drops. Those riders are expensive insurance that rarely pays off.

Avoid variable annuities unless you have a very specific reason and have had a fee-only financial advisor review the contract. The same goes for any annuity with multiple riders, income guarantees, or features you do not fully understand. If you cannot explain it in one sentence, it is probably too expensive.

Alternatives that often work better

For most people, a straightforward portfolio of low-cost index funds beats an annuity. You keep your money, you pay minimal fees, you can access it whenever you need it, and you can leave it to your heirs. If you are worried about running out of money, you can use a strategy called bucketing: keep one to two years of expenses in cash, five to ten years in bonds, and the rest in stocks. That gives you flexibility and growth without locking money away.

If you are retired and want may provide income, consider buying just enough of an when ready annuity to cover your essential expenses, and keep the rest invested. This is sometimes called a "floor and upside" strategy. Your floor is the may provide annuity income. Your upside is the growth from your remaining portfolio.

If you have a pension from an employer, you may already have the certainty an annuity provides. In that case, an annuity is redundant.

Frequently Asked Questions

Can I get my money back if I change my mind about an annuity?

Most annuities have a surrender period of 5 to 15 years. If you withdraw money during that time, you pay a surrender charge that starts at 7 to 10 percent and declines each year. After the surrender period ends, you can usually withdraw without penalty, but you may still owe taxes on any gains. Read the contract carefully before you buy.

Are annuities taxed differently than regular investments?

Yes. Money you withdraw from an annuity is taxed as ordinary income, not as capital gains (which are taxed at lower rates). This makes annuities less tax-efficient than holding stocks or index funds in a regular brokerage account. If you buy an annuity inside a retirement account like an IRA, the tax difference does not matter because the account is already tax-deferred.

What happens to my annuity if the insurance company goes out of business?

Each state has a guaranty fund that protects annuity holders if an insurance company fails. The protection limit varies by state but is typically $250,000 per person per company. Before buying an annuity, check your state's guaranty fund rules and verify the insurance company's financial rating through agencies like AM Best.

Is an annuity a good way to invest a lump sum from an inheritance or lawsuit settlement?

Not usually. If you receive a large sum at a younger age (before 65), you have time for that money to grow in a diversified portfolio. An annuity locks it away and charges high fees for the privilege. Consider working with a fee-only financial advisor to create an investment plan instead.

Do I need an annuity if I have Social Security and a pension?

Probably not. Social Security and a pension already provide may provide lifetime income. An annuity would be redundant. Instead, focus on investing any additional savings in a diversified portfolio that you can access if you need it.