Do Annuities Make Sense for You? What You Should Know Before Choosing One
- RetireAdvisers℠ of Pension Consultants, Inc.
- Mar 30
- 7 min read
Key Takeaways:
Annuities are often marketed as a way to create predictable income in retirement.
By converting savings into scheduled payments, annuities aim to provide a steady income stream that may last for a set period or for life.
However, annuities often involve tradeoffs that may not be immediately obvious.
Fees, contract restrictions, and complex product structures can affect flexibility, long-term growth potential, and access to funds.
Because of these factors, annuities are not a universal solution for retirement income.
Most individuals are able to generate the same income through diversified investment portfolios (without many of the costs, restrictions, or complexities often associated with annuity contracts).
Annuities are often marketed as a solution to one of retirement’s biggest fears: running out of money. The pitch is simple. Convert your savings into a guaranteed stream of income that lasts for life.
For many individuals, that sounds reassuring. But within the retirement planning industry, annuities are also one of the most debated financial products.
Some individuals are satisfied with their annuities and appreciate the income stability they provide. At the same time, many financial professionals question whether annuities are the most effective way to generate retirement income.
In our experience, those who purchase annuities could have achieved similar results using more flexible strategies, and in some cases, would have benefited from maintaining greater control over their assets. Which is why understanding annuities requires looking beyond the sales pitch and examining how these products actually work.
What Is an Annuity?
An annuity is a contract between an individual and an insurance company. In exchange for a lump sum or series of payments, the insurance company will provide income payments in the future, often during retirement. Some annuities begin paying income immediately. Others allow the investment to grow for several years before payments begin.
At a high level, annuities attempt to convert savings into predictable income. However, the structure of the contract, including fees, restrictions, and investment options, can significantly affect whether the product ultimately benefits the retiree.
Why Annuities Are Often Sold
The appeal of annuities usually centers around three core ideas:
Guaranteed lifetime income
Protection from market uncertainty
Simplicity in retirement income planning
For those concerned about market swings or longevity risk, these features can feel reassuring. However, even though these features can be appealing, they are typically supported through the structure of the contract, which may include fees, restrictions, or reduced long-term growth potential.
Common Types of Annuities
Fixed Annuities
Fixed annuities offer a predetermined interest rate and predictable income payments. Because the return is known in advance, they are often viewed as one of the simpler annuity structures. However, fixed annuities may offer lower long-term growth potential compared with diversified investment portfolios.
Variable Annuities
Variable annuities allow the account value to fluctuate based on underlying investments, often similar to mutual funds. This structure introduces the potential for growth but also exposes the investor to market volatility. Variable annuities are also frequently associated with higher fees and more complex product structures.
Immediate Annuities
Immediate annuities convert a lump sum of money into income payments that begin shortly after the contract is purchased. These payments may continue for a set period of time or for the remainder of the individual’s life, depending on the structure of the contract.
The Real Tradeoffs Behind Annuities
While annuities can provide income stability, they often introduce tradeoffs that are not always fully understood at the time of purchase.
Fees Can Be Significant
Some annuities include multiple layers of fees, particularly variable annuities. These costs can include:
Mortality and expense charges
Administrative fees
Investment management expenses
Optional rider fees
Why Fees Matter in Retirement
Understanding fees is one of the most important parts of evaluating financial products. Different compensation models and product structures can affect how much of your money stays invested over time.
Liquidity Can Be Limited
One of the most commonly misunderstood aspects of annuities is liquidity, and it can also be one of the biggest challenges they create. Many annuity contracts include surrender periods that restrict withdrawals for several years. During that time, accessing more than a limited portion of your savings may trigger penalties, which can make it difficult to adjust if financial needs change unexpectedly during retirement.
Complexity Can Make Evaluation Difficult
Some annuities include complex rider structures, income guarantees, and benefit formulas. For many people, understanding how these features interact can be difficult without careful analysis. Even experienced professionals often need time to fully evaluate these contracts.
Tax Considerations with Annuities
Annuities are often promoted for their tax advantages, particularly the ability to grow investments without paying taxes each year. However, the tax treatment of annuities can be more complex than many investors realize, and in some situations it may be less favorable than other investment options.
Potential Tax Advantages:
Tax-Deferred Growth
Earnings inside an annuity generally grow tax-deferred, meaning taxes are not owed until funds are withdrawn. This allows the investment to compound over time, although many retirement accounts already offer similar tax treatment.
Possible Tax Bracket Differences in Retirement
Some individuals may be in a lower income tax bracket once they begin taking withdrawals, which could reduce the taxes owed on annuity income. Whether this occurs depends on an individual’s broader retirement income situation.
Flexible Payout Structures
Annuities offer several payout options, allowing withdrawals to be structured in different ways that may help manage taxable income.
Potential Tax Drawbacks:
Despite these potential advantages, annuities also introduce several tax considerations.
Earnings Are Taxed as Ordinary Income
Investment gains withdrawn from an annuity are typically taxed as ordinary income rather than at lower long-term capital gains rates, which may increase the tax burden compared with other investments.
Early Withdrawal Penalties
Withdrawals before age 59½ may trigger a 10% federal penalty in addition to income taxes on the earnings portion, with limited exceptions [1].
Complex Tax Rules
Tax treatment can vary depending on whether the annuity is qualified (funded with pre-tax dollars through retirement plans) or non-qualified (funded with after-tax dollars). Qualified annuities are generally taxed entirely upon withdrawal and are subject to required minimum distributions later in retirement, while non-qualified annuities tax only the earnings portion when withdrawn.
Because of these complexities, understanding how annuities are taxed and how they compare with other investment strategies can be an important part of evaluating whether they fit into a retirement plan.
Why Annuities Are Not Our Choice
At RetireAdvisers℠, annuities are not the solution we consider when evaluating retirement income strategies. In many cases, the same income objectives can be addressed through diversified portfolios and investment-grade fixed income while preserving greater transparency, flexibility, and control over assets.
That does not mean annuities never serve a purpose. Some retirees appreciate the predictable payments they provide and are comfortable with the tradeoffs involved. However, in many situations those tradeoffs can be significant.
Many retirees already receive a form of lifetime income through Social Security. Social Security benefits are adjusted periodically through cost-of-living adjustments (COLAs), which are designed to help income keep pace with inflation over time. Adding another income contract on top of that may duplicate a feature retirees already have while introducing new costs, restrictions, or complexity, particularly since most standard annuities do not automatically adjust for inflation.
More importantly, retirement income can often be generated through diversified portfolios and structured withdrawal strategies that allow people to maintain control of their assets. When investments remain accessible, income strategies can be adjusted over time as markets change, spending needs evolve, or tax considerations shift. Once assets are converted into an annuity contract, many of those decisions become far more difficult to change.
Our process begins by evaluating how your investments, income needs, and time horizon work together. Rather than locking savings into a single product, we typically prioritize strategies that maintain flexibility, allow for ongoing adjustments, and align the investment portfolio with long-term retirement goals.
Alternatives That Many Investors Use Instead
Annuities are often positioned as a way to create stable, predictable income in retirement. However, similar outcomes can often be achieved through more flexible investment strategies, without the added complexity, restrictions, or long-term commitments that annuities may involve.
Fixed Income Can Do the Same Job
Investments like U.S. Treasuries, investment-grade bonds, and certificates of deposit (CDs) are designed to provide income and stability, serving the same core purpose annuities aim to deliver. The difference is flexibility.
With fixed income, if your needs change or you simply decide to go a different direction, you can sell those investments and use your money. There are no long-term surrender periods or penalties tied to accessing your funds. That level of control can be especially important in retirement, where priorities and circumstances may evolve over time.
Growth Still Matters in Retirement
Beyond stability, many retirement strategies are built using a diversified portfolio that includes a mix of equities, fixed income, and cash. This allows your investments to do more than just generate income. It gives them the opportunity to continue growing over time, and allowing investors to see a greater return over time. Rather than converting your savings into a fixed stream of payments, your money remains invested, accessible, and adaptable. This means you can adjust your strategy, respond to changing needs, and maintain the potential for assets to remain over time, whether for future expenses or to pass along to family.
The key is not choosing a single product, but building a strategy, which is where the RetireAdvisers℠ team can fit in. We work through the details with you: how to balance income and growth, how much risk is appropriate, and how to structure a portfolio that aligns with your goals. Instead of locking into a fixed solution, the focus is on creating a plan that can evolve, while keeping you in control of your financial decisions. To see how these pieces come together in practice, you can explore our article, Building a Retirement Distribution Plan: Turning Savings Into Sustainable Income.
Why Annuities Aren’t a One-Size-Fits-All Solution
Retirement income planning rarely depends on a single product. Instead, it involves coordinating investments, withdrawals, taxes, and long-term spending needs in a way that supports both stability and flexibility over time. While annuities may play a role for some individuals, they are only one possible tool within a much broader retirement planning framework. Exploring how different strategies work together can help you make more informed decisions about how your savings will eventually support you throughout retirement.
If you would like to explore how your retirement income strategy is structured, the RetireAdvisers℠ team can help you evaluate those decisions within the context of your overall financial plan.
The concepts expressed herein represent the views and opinions of Pension Consultants, Inc., and are not intended as legal, tax, or investment advice for any specific individual, account, or plan.
Source:
[1] “Retirement Topics: Exceptions to Tax on Early Distributions | Internal Revenue Service.” Www.irs.gov, www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-on-early-distributions.
