An annuity is less an investment than a way to buy income you cannot outlive. It can make sense when your guaranteed income (Social Security, a pension) does not cover your essential bills and you want the gap filled no matter what markets do or how long you live. The price is less access to your money, and the guarantee is only as strong as the insurer.
Annuities are not right for every household. They trade liquidity for guarantees, and that trade only makes sense when the gap between your guaranteed income and your essential spending justifies the cost.
What does an annuity actually do?
It moves three risks off you and onto an insurance company:
- Living longer than your money. Lifetime income keeps paying at 92, 95 or 100.
- A bad market early in retirement. The income does not depend on what the market did the year you retired. See sequence of returns risk.
- Your own reactions under stress. A check that arrives every month is easier to live with than a balance that swings.
What are the downsides of an annuity?
- Less access to your money. Turning savings into lifetime income can be hard or impossible to reverse. Many contracts charge surrender fees for early withdrawals.
- Costs. Riders, caps and fees vary widely and are not always easy to see.
- The insurer’s strength matters. Guarantees depend on the insurance company’s ability to pay claims.
- Less left to heirs in some structures, unless the contract includes a guaranteed period or death benefit.
Annuity or bond portfolio: which gives more retirement income?
An annuity pays more each year than a bond portfolio of the same size, and it keeps paying for life. A bond portfolio that pays the same amount has to sell principal every year, so it eventually runs out. How the annuity is taxed depends on whether it is bought with pre-tax or after-tax money.
An illustration from Financial Fortress: Herschel. Herschel is 70, has $2,000,000 saved and needs $143,200 a year for life. He compares two ways to get it, first with money from his traditional IRA and then with after-tax money.
Example 1: paid for from his IRA (pre-tax)
Both options are funded from the IRA, so every dollar of income is taxed the same way. The only difference is how long the income lasts.
| Lifetime annuity (20 years guaranteed) | Bond portfolio at 4.25% | |
|---|---|---|
| Yearly income | $143,200 | $143,200 |
| Year one | All contractual income | $85,000 of interest plus $58,200 of principal sold |
| Money runs out | Never | About age 90 |
| If Herschel dies early | Remaining guaranteed payments go to his heirs | The balance goes to his heirs |
| Risk of living too long | Moved to the insurer | Stays with Herschel |
Example 2: paid for with after-tax money
When an annuity is bought with after-tax money, part of each payment is treated as a return of what you paid in, and that part is not taxed. For Herschel, $100,000 of each $143,200 payment is tax-free until his $2,000,000 has been paid back, and the other $43,200 is taxed as income. Herschel also has $50,000 a year of Social Security and a $50,000 pension. The bond portfolio is set up to give him the same after-tax income each year.
| Year (age) | Annuity: tax-free / taxable | Bonds: tax-free / taxable | Bond balance left |
|---|---|---|---|
| 1 (71) | $100k / $43k | $68k / $85k | $1,932k |
| 10 (80) | $100k / $43k | $91k / $55k | $1,209k |
| 20 (90) | $100k / $43k | $125k / $11k | $122k |
| 21 (91) | $0 / $143k | $103k / $5k | $19k |
| 22 (92) | $0 / $143k | $19k / $1k | Zero |
For twenty years the annuity’s tax-free portion keeps Herschel’s taxable income lower. In year 21 the tax-free portion ends and the full payment becomes taxable, a change he can see coming and plan for. In year 22 the bond portfolio runs out. Herschel is 92, and the annuity is still paying.
Illustrative composite from the book, not a client and not a quote. Simplified: constant yields, 85% of Social Security taxable, standard deduction, no state income tax; dollars rounded to the nearest thousand. The 7.16% payout rate is a contractual income factor, not an investment return: each payment includes a return of the original principal. Guarantees depend on the insurer’s claims-paying ability; annuitization reduces liquidity and may be difficult to reverse.
The higher annuity payment is not a magic yield. It comes from three things: the insurer’s own investment return, part of your principal coming back in each payment, and pooling: people who live shorter lives help pay for those who live longer.
Having enough at seventy solves nothing if the money is gone before you are.
Isn’t the 4% rule enough?
The 4% rule says you can withdraw 4% of your portfolio each year. It is a withdrawal habit, not an income plan. The whole portfolio stays invested, so a bad early market, a long life and your own nerves are all still your problem. It can look fine on a spreadsheet and feel very different to live through.
Lifetime income does not promise better returns. It takes the market out of the income itself.
What types of annuities are there?
| Type | What it does |
|---|---|
| Immediate income annuity | Turns a lump sum into income that starts now, for life or a set period. |
| Deferred income annuity | Income starts at a later date; waiting raises the payment. |
| Multi-year guaranteed annuity (MYGA) | A fixed rate for a set number of years, similar in idea to a CD. MYGA vs CD and bonds |
| Fixed indexed annuity | Growth linked to a market index with a 0% floor and a cap; often paired with an income rider. |
| Registered index-linked annuity (RILA) | More market upside than a fixed indexed annuity, with a buffer that absorbs part of a loss. What is a RILA? |
Questions to ask your advisor
- What specific part of my plan keeps income coming if I live past 90, and what happens if it doesn’t?
- How much of my essential spending is covered by guaranteed income today, and what is the gap?
- If an annuity makes sense, should it be funded with pre-tax or after-tax money, and how does that change what I keep?
- What does this contract cost each year, what are the surrender charges, and how strong is the insurer?
More retirement questions: When can I retire, and will I have enough?
Related questions
Want to know whether any of your income should be guaranteed?
Schedule a conversation or read Chapter 1 of Financial Fortress.
This page is general education, not advice for your situation. Annuities are insurance products; guarantees are backed by the issuing insurer’s claims-paying ability. Ira Koyner is a licensed insurance agent and may earn a commission on insurance products. Triathlon Partners LLC is a registered investment adviser in Connecticut and New York. Registration does not imply a certain level of skill or training.