Annuities, briefly and skeptically

An annuity is a contract with an insurer. In exchange for a premium, the insurer promises payments — immediately or in the future.

The core function is genuinely valuable: converting a sum of money into income that cannot be outlived. The market around that function contains products of widely varying cost and complexity.

The main types

Single premium immediate annuity. You pay a lump sum and receive income starting immediately, for life or a defined period.

The simplest form and the one that most directly addresses longevity risk.

Costs are embedded in the payout rate rather than charged separately, and rates are comparable between insurers, which makes shopping straightforward.

Deferred income annuity. You pay now and income begins at a future date. Longer deferral produces higher income.

A version designed to begin at an advanced age, sometimes called longevity insurance, addresses the specific risk of living far longer than expected at relatively low cost.

Fixed annuity. Accumulates at a declared interest rate, with a guaranteed minimum. Functions somewhat like a certificate of deposit with different tax treatment and different guarantees.

Fixed indexed annuity. Credits interest linked to an index, with a floor of zero and a cap or participation rate limiting the upside.

The insurer can typically adjust caps and participation rates, so illustrated returns based on current terms may not persist.

Variable annuity. Invests in subaccounts with market exposure. Values can decline.

Frequently sold with living benefit riders guaranteeing minimum income or withdrawal amounts, at additional cost.

The cost question

This is where the variation is largest.

Immediate annuities have costs built into the payout rate, and competition means rates are reasonably comparable.

Variable and indexed annuities can carry several layers: mortality and expense charges, administrative fees, subaccount expenses, and rider charges.

Total ongoing costs on some variable annuities with riders have historically run to several percent annually, which is a substantial drag over decades.

Ask for every charge, itemized, as an annual percentage, and add them up.

Surrender charges

Most deferred annuities impose surrender charges for early withdrawal, declining over a period that is commonly five to ten years and occasionally longer.

Charges can start in the high single digits.

This makes the money genuinely illiquid, which is a serious consideration for anyone who might need it.

Most contracts allow a limited free withdrawal annually, commonly ten percent.

Tax treatment

Growth inside a non-qualified annuity is tax-deferred.

Withdrawals from a non-qualified deferred annuity are generally taxed on a gain-first basis, as ordinary income, and may face an additional penalty before a specified age.

Annuitized payments are partly a return of basis and partly taxable, using an exclusion ratio.

Importantly, gains are taxed as ordinary income rather than at capital gains rates, which for a taxable investor is frequently less favorable than a taxable investment account.

A specific point: buying an annuity inside a retirement account for the tax deferral is redundant, since the account is already tax-deferred. There may be other reasons to do it, and tax deferral is not one, and this argument has been used in unsuitable sales.

Where annuities genuinely help

Longevity risk. The risk of outliving assets is real and hard to self-insure, because you cannot know how long you will live.

A lifetime income stream addresses this in a way no investment portfolio can.

Guaranteed baseline income. Covering essential expenses with guaranteed income — social security plus a modest annuity — allows the remaining portfolio to be invested with less anxiety.

This is a well-supported approach in retirement planning.

Behavioral simplicity, for someone who wants income without managing withdrawals.

The concerns

Complexity that obscures cost. Products with multiple riders, caps, participation rates and buffers are genuinely difficult to evaluate.

Commission incentives, which on some annuity products are substantial and which drive sales.

Illiquidity, through surrender charges.

Inflation, since a fixed payment loses purchasing power over decades. Inflation-adjusted annuities exist and start at a lower payment.

Credit risk. An annuity is a promise by an insurer. State guaranty associations provide limited protection up to specified amounts, which vary by state.

Insurer financial strength matters more here than in most insurance purchases, because the obligation may extend forty years.

The practical approach

If the objective is guaranteed lifetime income, a single premium immediate annuity or a deferred income annuity from a highly rated insurer is the direct route, and the products are comparable enough to shop on payout rate.

Consider annuitizing only a portion of assets — enough to cover essential expenses alongside other guaranteed income — rather than all of them.

Be cautious with complex products, and require every charge in writing.

Get an independent opinion from someone not compensated on the sale.

And use the free look period, which for annuities is generally longer than for other products, to read the actual contract.

General information about financial products, not insurance, investment or tax advice. Annuity terms, charges and tax treatment are complex and vary. Consult an independent advisor and a tax professional.