Annuities explained
One simple kind insures against a real risk. The complicated kinds mostly insure the seller’s income. How to tell them apart and what to ask.
A plain-language reference, not advice. Annuities are contracts with an insurer and vary enormously in terms and cost; this guide describes the main types and the questions to ask, and deliberately avoids product-specific figures. Anyone considering one should read the actual contract and, ideally, have a fee-only fiduciary review it.
Part of Financial 101 — free, plain-language reference guides. Not personalised advice. Download the one-page Order of Operations checklist.
In one sentence
An annuity is a contract with an insurance company that converts a lump sum into a stream of payments — a genuinely useful idea for insuring against outliving your money, wrapped, in most of the products actually sold, in enough complexity and cost that the Boglehead position is: understand the simple version, and be very sceptical of the rest.
The four main types
Single premium immediate annuity (SPIA). You hand over a lump sum; the insurer pays you a fixed amount monthly for life, starting now. Simple, transparent, and the one kind that has real supporters among cost-conscious investors. It is longevity insurance: it pools your risk of living to 100 with everyone else’s, which is something an index fund cannot do.
Deferred income annuity. The same idea, but payments start at a future date — say, age 80 — so the cost is much lower. Sometimes used as insurance against the tail end of a long retirement.
Fixed and fixed-indexed annuities. Accumulation products. A fixed annuity credits a guaranteed rate; a fixed-indexed annuity credits a return linked to a market index, but with caps, participation rates, and spreads that limit what you actually receive. Marketed as “market upside with no downside.” The downside is in the formula.
Variable annuities. An investment account inside an insurance wrapper, often with optional guaranteed-income riders. Historically among the most expensive retail financial products, with layered fees, surrender charges lasting many years, and commissions that create the incentive to sell them aggressively.
The simple annuity insures against a real risk. The complicated ones mostly insure the seller’s income.
When a simple annuity can make sense
For a retiree without a pension, whose Social Security does not cover essential expenses, and who is worried about running out of money late in life, a SPIA covering the gap between guaranteed income and essential spending can be a rational purchase. It buys peace of mind, it removes sequence-of-returns risk from that portion of spending, and its cost is visible. Most Boglehead-style thinking is not anti-annuity; it is anti-complexity, and a SPIA is the least complex financial product there is.
Why the rest deserve scepticism
Cost. Variable and indexed products frequently carry combined annual charges several times higher than an index fund portfolio, and those charges compound against you for decades.
Surrender charges. Many contracts penalise withdrawals for years after purchase. Your money is locked exactly when flexibility might matter.
Opacity. Caps, spreads, participation rates, rider fees, and mortality and expense charges interact in ways that are hard to evaluate even for professionals. If you cannot explain what you will receive under three different market scenarios, you do not understand the product.
Sales incentives. These products are sold, not bought. Commissions can be substantial, and the enthusiasm of the person recommending one is not evidence of its quality.
The comparison that matters. For accumulation, a diversified index portfolio in tax-advantaged accounts — the 401(k), the Roth IRA — achieves most of what these products promise at a fraction of the cost and with none of the lock-up. An annuity should be considered only after those are fully used, if at all.
Questions to ask before signing anything
What are all the fees, in total, per year? What is the surrender schedule and how long does it last? What exactly happens to the payment if the market falls 30%, is flat, or rises 30%? What is the insurer’s financial-strength rating? Is the person recommending this a fiduciary, and how are they paid? Can I get the same guaranteed income more cheaply by simply buying a SPIA later?
Common mistakes
Buying an annuity inside an IRA or 401(k). The account is already tax-deferred; you are paying for tax deferral twice.
Annuitising everything. Even a good SPIA should cover essential spending, not all your assets — you lose liquidity and inflation protection.
Mistaking a guarantee for a good deal. Guarantees are priced. The question is always what you paid for them.
Checklist
Tax-advantaged accounts fully funded first · Purpose clearly defined (longevity insurance vs. accumulation) · All fees written down as a single annual total · Surrender schedule understood · Payout illustrated under three market scenarios · Reviewed by a fee-only fiduciary who does not sell the product.
Related: Index funds · 401(k) basics · The full order of operations
Verification queue
Check each of these before publishing, then delete this block. Reference pages also need a yearly re-check when the IRS publishes new limits (usually November).
- Typical all-in annual cost ranges for variable and fixed-indexed annuities — only add figures with a named source (e.g. FINRA or SEC investor bulletins).
- Typical surrender-charge durations — same; cite FINRA/SEC or leave qualitative.
- Insurer financial-strength rating agencies to name — confirm before listing.
- State guaranty association coverage limits — vary by state; mention only qualitatively or with a source.
- Confirm the description of indexed-annuity crediting mechanics (caps, participation rates, spreads) against an SEC or FINRA explainer.
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