Annuities Explained: When They Make Sense (And When They Don't)

Annuities are one of those financial products that tend to polarize people. Some view them as essential for retirement security. Others see them as expensive and unnecessary. The truth is somewhere in the middle, and it depends heavily on your specific situation. Understanding what annuities are, how they work, and when they make sense will help you evaluate whether they belong in your retirement plan.

What Is an Annuity? At the simplest level, an annuity is a contract with an insurance company. You give the company money, and in return, it promises to make payments to you — either for a set period of time, or for the rest of your life, depending on the type of annuity. Annuities come in many varieties, with different features and different costs. Some are simple. Some are quite complex. Understanding the variety is important.

Immediate Annuities (Simple Annuities) An immediate annuity is the simplest form. You give an insurance company $500,000 (for example). In return, they promise to pay you a fixed amount each month for the rest of your life — say, $2,500 per month. You receive your money back over time as part of the monthly payment, and the insurance company takes the investment risk and longevity risk. Once you agree to the contract, the payment does not change. This provides genuine certainty — you know exactly what you will receive. The trade-off is that it is illiquid — once you purchase the annuity, you cannot easily access the principal. Some immediate annuities have 'return of principal' provisions, where a certain amount is guaranteed to pass to your heirs if you die early. But the basic contract is very straightforward.

When immediate annuities make sense: You are retired. You have more retirement savings than you need for healthcare and emergencies. You value the certainty of a guaranteed income stream and the ability to 'stop thinking' about part of your money. You do not need access to the principal. You are comfortable with the fact that your payments do not increase with inflation (though inflation-adjusted immediate annuities exist, at a higher cost). For many retirees, buying an immediate annuity with a portion of their savings — perhaps 25% to 50% — provides a floor of secure income that covers basic expenses. The rest of the portfolio can be invested for growth. This combination often feels comfortable.

When they do not make sense: You are still working. You might need access to the money. You expect to need flexibility. You distrust insurance companies or prefer to maintain control over your money. You have a family history of short lifespans and you would not expect to collect many payments. An immediate annuity 'works' for people who will collect a lot of payments over many years. For someone who might only receive five years of payments, the economics are not favorable.

Variable Annuities A variable annuity is a different beast. You put money into the contract, and the insurance company invests it in subaccounts (similar to mutual funds) that you choose. Your payments depend on the investment performance of those accounts. If the investments do well, your payments increase. If they do poorly, your payments decrease. Many variable annuities come with 'guarantees' — promises of a minimum return, or a guaranteed income rider that provides a minimum income stream regardless of investment performance. These sound good, but they come with costs. The fees on variable annuities can be substantial — 1% to 3% per year or more in total, between the insurance company's charges and the underlying fund fees.

When variable annuities might make sense: You want the combination of investment flexibility (you choose what to invest in) and a guaranteed income feature (if the market declines, you have a minimum income floor). You have significant assets and you do not mind paying relatively high fees for insurance guarantees. You want to leave a guaranteed amount to heirs. These situations exist, but they are less common than people think. For most investors, the combination of a diversified portfolio and a modest immediate annuity accomplishes similar goals at lower cost.

When they often don't make sense: You have average investor assets (say, $500K to $2M). You are comfortable managing risk and do not need insurance guarantees. You want simplicity and low costs. You do not want to be locked in for many years. Most investors are better served by a simple portfolio with an immediate annuity for a portion, rather than a variable annuity. The fees are the main reason — paying 2% to 3% annually for years is a significant drag on returns.

Indexed Annuities An indexed annuity is another variation. Your money is invested in a way that mirrors a stock market index (like the S&P 500), but with a 'floor' that limits downside and a 'cap' that limits upside. In a down year, you might receive 0% (rather than suffering the full decline). In a great year, you might receive 10% (rather than receiving the full market return if the market went up 25%). The idea is stability — less volatility than the market, but less risk. The trade-off is that you are giving up upside. Like other complex annuities, indexed annuities come with substantial fees, and they can be difficult to understand. Some indexed annuities have income riders, which add more complexity and more cost.

Annuities and Taxes One appealing feature of annuities is tax deferral. Money grows inside an annuity contract without generating annual tax liability. When you take distributions, the gains are taxed as ordinary income. If you own the annuity outside of a retirement account, the tax deferral is valuable. But if the annuity is inside an IRA (where the account is already tax-deferred), the tax-deferral feature of the annuity adds no benefit — you are paying high fees for a benefit you are already getting. This is a common mistake: people purchase annuities inside IRAs, essentially paying for tax deferral twice. If you are considering an annuity, make sure it is in a taxable account, not inside an IRA, unless you have a specific reason for wanting it inside the IRA.

What We Recommend In our practice, we sometimes recommend immediate annuities as part of a retirement plan. We rarely recommend variable annuities or indexed annuities, because for most clients, a simple diversified portfolio with some immediate annuity income provides better results at lower cost. If you are considering an annuity, ask yourself: What problem am I trying to solve? Am I seeking guaranteed income? If so, a simple immediate annuity is often better than a variable or indexed annuity. Am I seeking investment growth with downside protection? If so, you probably do not need an annuity — a diversified portfolio with appropriate guardrails accomplishes that goal. Am I seeking a legacy benefit? If so, there are cheaper ways to accomplish that than purchasing an annuity. Be very clear about what you are buying and why. Make sure you understand the costs. If you cannot easily explain the product to a friend, you probably do not understand it well enough to own it.

A Final Word Annuities are not inherently good or bad. They are tools that work well in some situations and not in others. The worst outcome is purchasing an annuity because you were convinced it was 'the answer' without genuinely understanding what you were buying or whether it solved an actual problem you have. Before you purchase any annuity, talk to a fiduciary advisor. Ask them to explain the costs. Ask them to model whether it would actually improve your retirement plan compared to alternatives. For Tampa Bay residents approaching retirement with substantial savings, a conversation about whether some form of annuity makes sense is a reasonable part of planning. But it should be a deliberate decision based on your specific needs, not a reaction to sales pressure or fear.