What Is an Annuity?

An older woman holding a camera to her eye

We work day after day, year after year, with the ultimate goal of retiring from the job and enjoying the remaining years of life. But that’s only possible if you save enough money to afford your retirement. Retirement savings options come in all shapes and sizes. In addition to stocks, bonds, and mutual funds, you can also consider an annuity.

Here’s what you need to know about this unique type of financial asset.

What Is an Annuity?

An annuity isn’t quite like other types of retirement funds. It is a contract between you and an insurance company. You agree to make a lump-sum payment or series of payments over time to the insurance company. In return, the insurance company offers regular disbursements of money back to you. These disbursements can begin immediately or in the future. Many people opt to have the payments start when they stop working as a replacement for that paycheck.

Most retirees use annuities to maintain a steady stream of income since they can be tailored to many different retirement situations. If you choose to use an annuity, you can customize the policy to suit your specific financial needs:

  • Choose between a lump-sum payment or a series of payments
  • Choose when you want to start receiving payments
  • Select the duration of disbursements, either for a set number of years or until your death

Just like other investments, annuities are available in different varieties depending on the level of risk you want to assume. Fixed annuities offer a guaranteed payout in return for a lower annual return. Variable annuities offer the chance of higher returns but, as is usually the case, with higher risks. If you select a variable annuity, you receive payments that will vary based on the performance of the mutual funds and other assets the annuity is invested in.

Many middle-of-the-road investors are opting for a third type: an index annuity. This type of investment is a good balance between risk and potential reward because it guarantees a minimum payout while also tying some of your investment to the performance of a market index like the Dow Jones Industrial Average or S&P 500.

What are the Pros and Cons of Annuities?

Every investment has its benefits and drawbacks, and annuities are no exception.

The core concept of an annuity is great you guarantee monthly income for the rest of your retirement. You can customize your annuity to your preferences and choose your level of risk. Annuities also grow tax-free, which is a nice perk compared to mutual funds, whose earnings and capital gains are taxed annually. Just keep in mind that all annuity payouts are subject to income tax upon disbursement.

On the downside, annuities usually charge higher fees than other types of retirement investments (up to 3%, which stings!). Insurance companies also place complex rules and restrictions on annuities that can be difficult to understand until it’s too late. For example, many retirees face steep fees if they try to access their funds in the first few years. Annuities are known for being inflexible in the face of an emergency; you get your monthly payout but can’t access the rest of your funds if needed.

The money you invest in annuities doesn’t reduce your taxable income, which is a con compared to 401(k) accounts or IRAs. You can work around this by only investing in annuities after you’ve maximized contributions to such pretax retirement accounts, but it’s still a factor to consider.

Should You Consider Buying an Annuity?

An annuity may not be the best option if you’re young and have time on your side to build up significant savings in stocks, bonds, and mutual funds. These all tend to offer better returns than annuities. However, if you’re close to retirement and ready to guarantee a stream of income for the next 30 years, a carefully selected annuity could do the trick.

Learn how to save now and retire early: Financial Independence Retire Early (FIRE) Explained.