What Is an Annuity?
An annuity is a financial contract between you and an insurance company where you make a lump-sum payment or series of payments in exchange for guaranteed regular disbursements that begin either immediately or at some point in the future. Annuities are primarily used as retirement income vehicles because they can provide a guaranteed stream of income for life or a specified period, effectively eliminating the risk of outliving your savings (longevity risk).
Annuities come in several varieties, each with different risk profiles, return potential, and fee structures. Understanding the differences between fixed, variable, and indexed annuities is essential for determining whether an annuity is right for your retirement plan. While annuities provide valuable guarantees, they also come with trade-offs including limited liquidity, potentially high fees, and complex contract terms.
Annuities are most valuable when you want guaranteed lifetime income, have already maxed out other tax-advantaged accounts (401k, IRA), want protection against market downturns, or need to create a pension-like income stream. They are generally not recommended as your only retirement investment.
Types of Annuities
| Feature | Fixed Annuity | Variable Annuity | Fixed Indexed Annuity |
|---|---|---|---|
| Return Type | Guaranteed fixed rate | Based on investment subaccounts | Linked to index (S&P 500) with cap and floor |
| Risk Level | Low (guaranteed) | Higher (market risk) | Moderate (protected downside) |
| Typical Returns | 3-5% | Varies (potentially 6-10%) | 3-7% (with caps) |
| Fees | Low (0-1%) | High (2-3.5%) | Moderate (1-2%) |
| Best For | Conservative investors wanting guarantees | Growth-seeking investors willing to accept risk | Investors wanting some market participation with protection |
| Liquidity | Limited (surrender charges 5-10 years) | Limited (surrender charges) | Limited (surrender charges) |
Annuity Payment Calculation
- 1Monthly rate: 5% / 12 = 0.4167%
- 2Number of payments: 20 x 12 = 240
- 3Monthly payment = $200,000 x [0.004167(1.004167)^240] / [(1.004167)^240 - 1]
- 4Monthly payment = $1,319.91
- 5Annual payment = $1,319.91 x 12 = $15,838.92
- 6Total payouts over 20 years = $1,319.91 x 240 = $316,778
- 7Total interest earned = $316,778 - $200,000 = $116,778
Pros and Cons of Annuities
- Pro: Guaranteed income for life or a set period, eliminating longevity risk
- Pro: Tax-deferred growth during the accumulation phase
- Pro: Fixed annuities provide predictable, stable income regardless of market conditions
- Pro: Can create a pension-like income stream for retirees without a traditional pension
- Con: High fees on variable annuities (mortality charges, administrative fees, investment management fees) can total 2-3.5%
- Con: Surrender charges typically apply for 5-10 years, limiting access to your money
- Con: Income payments from non-qualified annuities are taxed as ordinary income (not capital gains rates)
- Con: Less flexible than a systematic withdrawal from an investment portfolio
- Con: If you die early, the insurance company may keep the remaining balance (depends on contract terms)
Annuity Buying Guide
Steps to Evaluate an Annuity
Annuities in Canada
Canadian annuities function similarly to US annuities but are regulated provincially. Canadian investors can purchase annuities within their RRSP or RRIF to convert tax-deferred savings into guaranteed retirement income. Prescribed annuities in non-registered accounts receive favorable tax treatment where each payment is considered a blend of return of capital and interest, resulting in a level tax amount each year. Assuris (Canada's insurance guarantee corporation) protects annuity holders for up to $2,000/month or 85% of the promised benefit, whichever is higher.
Never put all your retirement savings into an annuity. Maintain liquid investments for emergencies and flexibility. Be cautious of high-pressure sales tactics and overly complex products with hidden fees. Consider working with a fee-only financial advisor (not a commission-based insurance agent) to evaluate whether an annuity is appropriate for your situation.