How to Know if Annuities Are a Good Investment for You

Often used to supplement retirement income, annuities are still a popular choice for many investors. In fact, robust demand persists; according to data published by the LIMRA (a trade association for the insurance and financial services industry), total annuity sales reached a record high of $432.4 billion in 2024 to represent 12% year-over-year growth. While this is an attractive investment option for many, however, annuities aren’t for everyone. Read this post to learn our thoughts on when you should (and shouldn’t) buy one.

What is an annuity?

An annuity is a type of insurance product that gives investors a guaranteed stream of income, with money paid up front (via a lump sum or series of payments) then invested and later paid out per an agreed-upon time, amount, and timeframe.

All annuities have two components—the principal you pay into it and returns on the same—and are funded with either pre-tax (qualified annuity) or post-tax (non-qualified annuity) dollars, depending on the type. Regardless of which option you choose, annuity account investments can grow tax-free.

Annuities are not insured by the FDIC nor any federal government agency, though state guaranty associations (nonprofit organizations regulated at the state level) do provide a safety net for policyholders; specific coverage amounts vary by state but are generally up to $250,000, per http://www.annuity.org.

Types of annuities

There are two basic annuity categories: “immediate” and “deferred.”

Immediate annuities

An immediate annuity provides a guaranteed income stream (often within a year) in exchange for paying a lump sum today.

Deferred annuities

With deferred annuities, you can contribute a series of payments (or a lump sum) and begin collecting income at a set point in the future. Investments grow tax-deferred, with payments typically continuing to grow as you delay collecting, and you have the option of receiving payments for life or instead over a set period of time (for both immediate and deferred annuities).

As with many other retirement vehicles, you’ll face a 10% penalty on any funds cashed out prior to age 59½ (applies to both as well).

How annuities work

Three main types of annuities—fixed, variable, and indexed—fall within these two categories, each working a little differently.

Fixed annuities

Fixed annuities are pretty straightforward, with your contract outlining future payment amounts and when they commence. You’ll have no control over how the money is invested, though, which in fact doesn’t matter as the rate of return is predetermined and guaranteed (akin to a CD). One drawback of a fixed annuity? Inflation may erode the value of your payout, a risky prospect if you plan to use it to pay the bills during retirement.

Variable annuities

Variable annuities serve to combat inflation risk with market exposure and give you higher returns, with money in these accounts therefore often invested in various stocks, bonds, and mutual funds (“subaccounts”). This makes variable annuities inherently riskier than their fixed counterparts—as your account balance and future payouts can vary based on financial market performance—and they’re also not entirely guaranteed, unlike fixed annuities. Such features explain why variable annuities are considered securities rather than insurance products, as brokers or financial advisors who sell you a variable annuity must be registered with the U.S. Securities and Exchange Commission.

Indexed annuities

Indexed annuities—also known as “equity-indexed” or “fixed index” annuities—are a hybrid of fixed and variable options and combine a minimum guaranteed interest rate with a rate linked to a market index (e.g., the S&P 500) or various market segments. Returns therefore typically fall between those of fixed and variable options.

With hybrid annuities, it’s important to consider participation rates (a percentage of an index’s return credited to your annuity). If your annuity has a participation rate of 70%, for example, this means index-linked returns would only amount to 70% of gains associated with the index; if your annuity was linked to the Dow Jones Industrial Average, and the Dow grew by 10%, you’d be credited with a 7% increase in this case.

Popular annuity riders

It’s important to note that annuities offer optional—though sometimes costly—add-on features (“riders”) to help minimize some of your risk. Here are some of the most common:

Guaranteed minimum income benefit (GMIB)

A guaranteed minimum income benefit (GMIB) rider offers floor caps—a guaranteed dollar or percentage the insurance company must pay you—that can minimize losses should your underlying investments take a nosedive. These riders are often associated with variable and fixed-index annuities.

Guaranteed minimum withdrawal benefit (GMWB)

A guaranteed minimum withdrawal benefit (GMWB) is a type of rider offering an enhanced feature compared to the aforementioned GMIB and is typically more expensive—but often more appealing to investors—since it allows you to withdraw a guaranteed percentage of your principal no matter how the investment performs.

Guaranteed minimum accumulation benefit (GMAB)

A guaranteed minimum accumulation benefit (GMAB) rider, often associated with variable annuities, can guarantee your account value will equal a fixed percentage of your premiums and therefore removes the risk of poor investment performance.

Death benefit

Death riders—ensuring beneficiaries receive a payout if you pass away prematurely—have also grown into a popular add-on, especially with respect to variable annuity contracts whereby they’re designed to protect your account value for a fee.

You can also add on an enhanced death benefit wherein the highest monthly (or annual, depending on the contract) recorded value of your account becomes the benefit upon your death. A death benefit on a variable annuity is also a popular choice for individuals who cannot qualify for life insurance since an underwriting requirement does not exist in this case.

Living benefit rider

Living benefit riders are also often added to variable annuity contracts and generally guarantee some sort of defined payout during the account owner’s lifetime, regardless of stock market performance.

Investment circumstances ripe for an annuity

As the goal of an annuity is to give you a steady stream of income (typically during retirement), these are often appropriate investments if you are:

A conservative investor

If you’re a risk-averse investor who wants to create a guaranteed source of income for the rest of your life, an annuity (especially a fixed annuity) may make sense.

Worried about running out of money during retirement

Since we’re living longer, we need to save more—plain and simple. It’s likewise no surprise that the top retirement concern among pre-retirees and retirees is running out of money, highlighting an annuity as a great choice in this case as it provides a guaranteed income stream for life.

Wanting to protect your legacy

As mentioned earlier, including a death rider in your annuity means you can pass it on to one or more named beneficiaries should you pass away prematurely.

Beyond contribution limits for all other retirement accounts

If you already maxed out contributions for all other retirement vehicles but want to continue funding your retirement, an annuity may make sense.

Reasons to avoid an annuity

Annuities aren’t for everyone. Disadvantages to owning one include:

Their complexity

Annuities are sometimes complex (some needlessly) and come with a wealth of perplexing features. They’re also expensive and often include a variety of fees that can make this type of investment even less attractive. For example, many include a “surrender period”—the timeframe you must keep your funds in the annuity to avoid paying fees—that can lead to surrender charges should you need to access funds sooner than anticipated.

You may see better returns elsewhere

Another reason to avoid purchasing an annuity is that you may be able to achieve better returns elsewhere. This is a critical consideration, especially if you haven’t maxed out other retirement vehicles such as a 401(k) and IRA yet. It’s also possible to lose more than just your returns as the same could happen to your principal, depending on the type of annuity you decide to purchase.

Your insurance company could go belly up

Finally, if the insurance company that sold your annuity goes bankrupt, this can adversely impact your payouts given limited coverage with state guaranty associations. It’s therefore important to select a reputable insurance company with a long track record of financial strength when buying one.

Fees

Annuities are known for carrying higher fees compared to other investment options because you're paying for a certain level of insurance that gives investors a healthy degree of financial security. Costs can increase significantly—sometimes exceeding 3% of the investment—when incorporating riders, and while some individuals may deem these added protections valuable and worth the expense, others may believe the fees outweigh the benefits (stifling the appeal of this investment choice).

How annuities are taxed: qualified vs. nonqualified

While “qualified” annuities are funded with pre-tax money—often by transferring money from a 401(k), IRA, or other tax-deferred retirement account—"non-qualified” annuities use after-tax dollars, with only the earnings portion taxed at withdrawal (whereas the entire amount is subject to taxation with qualified annuities).

Qualified annuities are also subject to required minimum distributions (RMDs)—withdrawals mandated by the IRS for those age 73+ (age 75+ beginning in 2033)—whereas non-qualified annuities are not. Finally, only qualified annuities have annual maximum contribution limits set by the IRS.

In sum: how to determine if annuities are right for you

Determining whether or not an annuity is right for you isn’t an easy decision, which is precisely why seeking advice from an independent financial advisor is so important: giving you the clarity and guidance you need to make the right decision.

Still have questions about annuities? Schedule a FREE discovery call with one of our CFP® professionals to get them answered.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. Schedule a no-obligation consultation with one of our financial advisors today!

Disclosures:
This document is a summary only and not intended to provide specific advice or recommendations for any individual.

Fixed and variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Withdrawals made prior to age 59½ are subject to a 10% IRS penalty tax, and surrender charges may apply. Variable annuities are subject to market risk and may lose value. Riders are additional guarantee options that are available to an annuity or life insurance contract holder. While some riders are part of an existing contract, many others may carry additional fees, charges, and restrictions, and policyholders should review their contract carefully before purchasing. All guarantees are based on the claims-paying ability of the issuing insurance company.