I’m taking classes toward earning my Certified Financial Planner (CFP®) designation, and one of the products we’ve had to study in detail is the annuity. I’ve seen annuities marketed as a safe “investment” and have seen mention of them pop up more in my socials. And they can be an important piece of a retirement plan – but not for everyone and they come with a lot of constraints. In this post I want to provide some basic information on annuities. In my next post, I’ll break down what annuities look like in the real world and who they might actually make sense for.
Annuities are often talked about like they’re mysterious or complicated. At their core, they’re actually pretty simple.
An annuity is an insurance contract designed to reduce longevity risk. Longevity Risk is just a fancy way of saying: the risk that you outlive your money.
Here’s how it works.
You give an insurance company money (either as a lump sum or over time) and in return, they promise to pay you income at some point in the future.
That’s it. That’s the basic structure.
What an Annuity Is (and Isn’t)
An annuity is an insurance product. It is not an investment – even if the money inside the annuity is invested, and even if someone is selling it to you like one.
When you buy an annuity, you are entering into a contract with an insurance company.
You contribute money.
Later, you can “annuitize” the contract. Annuitize is a fancy way of saying converting the account value into a stream of income.
Once you annuitize, the insurance company keeps the underlying principal and pays you according to the payout structure you chose.
Common Annuity Payout Options
When you decide to turn the annuity into income, you choose how long that income lasts. Common options include:
- Life Only – You receive payments for as long as you live.
- Life with Period Certain – You receive payments for life, but if you die early, payments continue to a beneficiary for a set number of years.
- Joint and Survivor – Payments last for both your lifetime and your spouse’s lifetime.
- Period Certain – Payments last for a specific number of years (like 10 or 20), even if you’re still alive when they end.
The longer or more protective the payout option, the lower the monthly payment tends to be. That’s because the insurance company is taking on more risk.
Before You Annuitize
Before income starts, the annuity is simply accumulating value. During this phase, there may be:
• Rules
• Fees
• Surrender periods
• Withdrawal limitations
Here’s what that actually means:
Rules
When I say “rules,” I’m talking about the contractual terms that govern what you can and can’t do with your money while it’s inside the annuity.
For example:
• You may not be able to freely move your money in and out of the contract like you would a savings account
• There are often specific timelines for when you can start income
• Some contracts limit how you can invest the underlying funds (if applicable)
• Each annuity has its own set of terms around how and when you can make changes
The key idea is that this is not a fully flexible account. An annuity is a contract with conditions attached. The basic premise for these rules is that the insurance company wants to limit your access to it so that they can structure it to provide payments to you later.
Fees
Most annuities come with multiple layers of fees, which can vary depending on the type of annuity.
These may include:
• Administrative or maintenance fees for keeping the contract active
• Investment management fees (for annuities with underlying investments)
• Mortality and expense (M&E) charges, which compensate the insurer for the guarantees they provide
• Rider fees, if you add optional features to the contract
Some annuities are marketed as “no commission,” but that typically means compensation is built into other fee structures.
Surrender Periods
A surrender period is a set number of years during which it is expensive to exit the annuity.
If you withdraw more than the allowed amount or cancel the contract during this period, you may face a surrender charge. Surrender charges are punitive and can cost upwards of 10% or more of the contracted amount of the annuity. For example, if you cancel a $100k annuity, and there’s a 8% surrender, you’ll have to pay $8,000 to cancel the annuity.
These periods often last anywhere from 5 to 10+ years, and the penalty typically declines over time.
Withdrawal Limitations
Even if you don’t fully exit the annuity, there are often limits on how much you can access each year.
For example:
• Many annuities allow “free withdrawals” of up to about 10% of the account value annually
• Withdrawals above that amount may trigger surrender charges
• Early withdrawals (before age 59½) may also be subject to IRS penalties, depending on the situation
This means your money may not be as liquid as it would be in a traditional brokerage or savings account. Once you annuitize, you’ve traded access to that lump sum for predictable payments. And that’s the point of annuities.
How This Compares to Pensions and Social Security
If this structure sounds familiar, it should.
Traditional pensions and Social Security function very similarly. You pay in during your working years and receive income for life in retirement.
In that sense, many of us already have annuity-like income built into our retirement plan. You can check out what your social security payment in retirement will be based on the age you tap it by logging into this the social security administration website: https://www.ssa.gov/
The Two Main Types of Income Annuities
There are two primary annuities designed specifically for income:
Single Premium Immediate Annuity (SPIA)
With a SPIA, you give the insurance company a lump sum and income begins shortly afterward — usually within a year.
This is often used by retirees who want to convert a portion of savings into guaranteed income right away.
Deferred Income Annuity (DIA)
With a DIA, you contribute money today, but income begins at a future date — sometimes 5, 10, 20, or even 30 years later. This kind of plan is often sold to people before they are retired.
In Theory
In theory, annuities are elegant. They transfer longevity risk from you to an insurance company. If you’re worried about running out of money in old age, they can provide predictable income. A lot of economists actually really like them, in theory.
In my next post, I’ll break down what annuities look like in the real world — including costs, tradeoffs, and who they might actually make sense for.
Cheers!!
Mrs. Moneyaire
