What an annuity is and how it works
An annuity is a contract you buy from an insurance company. You give them a lump sum of money (or make payments over time), and in return they promise to pay you a steady income for a set period — often for the rest of your life. The appeal is predictability: you know exactly how much will arrive each month, which can make budgeting easier in retirement.
The insurance company invests your money and keeps some of the return. What you receive depends on your age when you buy, how long you're expected to live, and current interest rates. A 65-year-old will receive a different monthly payment than a 75-year-old who puts in the same amount, because the company expects to pay out for fewer years.
There are several types. A fixed annuity pays the same amount every month no matter what happens in the market. A variable annuity ties your payments to the performance of investments you choose, so the amount can go up or down. An when ready annuity starts paying you right away; a deferred annuity lets your money grow for years before payments begin.
Key Takeaways
- An annuity trades a lump sum for may provide monthly income, which removes investment risk but locks your money away.
- Fixed annuities pay the same amount every month; variable annuities fluctuate based on market performance.
- Annuities carry high fees (often 1 to 3 percent annually) and surrender charges if you need your money back early.
- An annuity makes sense if you have other savings, want to reduce investment worry, and don't expect to need the principal back.
- Before buying, compare quotes from multiple insurers and understand exactly what fees you're paying and what happens if you die.
The real costs: fees and surrender charges
Annuities are not free to own. Most charge an annual fee ranging from 1 to 3 percent of your account balance, though some are higher. These fees pay for the insurance company's overhead, the agent's commission, and the cost of guaranteeing your income. Over 20 years, a 2 percent annual fee can reduce your total payout by a significant amount.
Many annuities also have surrender charges — penalties if you withdraw money beyond a small annual amount (often 10 percent) during the first 5 to 10 years. If you need access to your principal and the surrender period is still active, you may lose 5 to 10 percent of what you withdraw. This matters if your health changes, you face an unexpected expense, or you straightforward change your mind.
Variable annuities tend to cost more than fixed ones because you're paying for investment management and the option to move money between funds. Some variable annuities also charge for riders — add-ons that may provide a minimum income or protect against market losses. Each rider adds to the annual cost.
When an annuity might make sense
An annuity can be useful if you have already saved enough for emergencies and major expenses, and you want to turn part of that savings into may provide income you cannot outlive. This is especially true if you're worried about market downturns or if managing investments feels stressful. Knowing that a portion of your monthly expenses is covered no matter what the stock market does can reduce anxiety.
Annuities also work well if you've received a large lump sum — an inheritance, a pension buyout, or a lawsuit settlement — and you want to convert part of it into steady income without having to make investment decisions. Some people use an annuity to cover essential expenses (housing, utilities, food) and keep other savings for flexibility and growth.
If you're in good health and expect to live into your 90s, an annuity can pay out more over your lifetime than you would have earned by investing the money yourself, especially if interest rates are high when you buy. The longer you live, the better the deal becomes.
When an annuity is usually not the right choice
An annuity locks up your money. If you think you might need access to the principal — for a major health expense, to help a family member, or straightforward because your situation might change — a surrender charge can be painful. If you have only modest savings and no emergency fund, an annuity can leave you too tight.
Annuities also make less sense if you already have a pension or substantial Social Security income that covers your basic needs. Adding another may provide income stream may be redundant. Similarly, if you're in poor health or have a family history of shorter lifespans, you may not live long enough for an annuity to pay back what you put in.
The high fees also matter more if you're buying a small annuity or if you plan to hold it for only a few years. A $50,000 annuity with a 2 percent annual fee costs $1,000 per year — money that could otherwise go toward your income. Over time, those fees compound.
How to compare annuities and what to ask
If you're considering an annuity, get quotes from at least three different insurance companies. The monthly payment can vary by 10 to 20 percent depending on the company, so shopping matters. You can request quotes from major insurers like Fidelity, Vanguard, Schwab, and when ready Annuities (an online broker that compares multiple carriers).
When you compare, ask for a clear breakdown of all annual fees, any surrender charges and how long they last, what happens to your money if you die before payments begin (does it go to your heirs or to the insurance company?), and whether the payment is fixed or variable. Ask whether the payment adjusts for inflation — most do not, which means your purchasing power shrinks over time.
Also ask about riders and whether they're worth the cost. A rider that guarantees a minimum income or protects your heirs sounds good, but it reduces your monthly payment and may not be necessary if you have other resources. Request the annuity's prospectus (the legal document that describes all terms) and read the fee section carefully.
Alternatives to consider before buying
A bond ladder — buying bonds that mature at different times over the next 10 to 20 years — provides predictable income without locking up your principal. You get your money back as each bond matures, and you can adjust your strategy if circumstances change.
A dividend-focused portfolio of stocks and funds can provide steady income that may grow over time, though it carries market risk. This approach gives you more flexibility and lower fees than an annuity, but requires you to manage the investment.
Delaying Social Security until age 70 (if you're healthy and can afford to wait) increases your monthly benefit by roughly 8 percent per year — a form of may provide income growth that many people overlook. This may be a better use of savings than buying an annuity.
You can also use a combination approach: buy a small when ready annuity to cover essential expenses, keep the rest of your savings in a diversified portfolio for growth and flexibility. This gives you some may provide income without putting all your eggs in one basket.
Questions to ask a financial advisor
If you're working with a financial advisor, ask whether they are a fiduciary — legally required to put your interests first. Some advisors earn commissions on annuity sales, which can create a conflict of interest. A fiduciary advisor must disclose this and explain why an annuity is in your best interest, not just theirs.
Ask your advisor to model what your retirement looks like with and without an annuity, showing how much income you'd have each month under each scenario. Ask them to explain the fees in dollars per year, not percentages. Ask what happens if you change your mind in year three or year eight. The answers should be clear and specific, not vague.
Frequently Asked Questions
Can I get my money back if I change my mind?
During the surrender period (usually 5 to 10 years), you can withdraw up to a small annual amount (often 10 percent) without penalty. Beyond that, you'll pay a surrender charge that starts high and decreases each year. After the surrender period ends, you can withdraw your remaining balance without penalty, though you'll lose the may provide income stream.
What happens to my annuity if I die?
It depends on the type you buy. Some annuities stop paying when you die, and any remaining balance goes to the insurance company. Others let you name a beneficiary who receives the remaining balance. Ask about this before you buy — it matters if leaving money to your heirs is important to you.
Do annuities protect me from inflation?
Most fixed annuities do not adjust for inflation, so your $2,000 monthly payment stays $2,000 even as prices rise. Some annuities offer an inflation rider that increases your payment by a set percentage each year, but this reduces your starting payment and adds to fees. It's worth considering if you expect to live a long time.
Is an annuity the same as a pension?
No. A pension is an employer-provided benefit you earn through work; you don't buy it. An annuity is a product you purchase from an insurance company. Some people use an annuity to replace a pension they didn't receive, or to convert a lump-sum pension payout into monthly income.
Should I buy an annuity with my entire retirement savings?
Most financial advisors recommend against it. Putting all your money into an annuity removes flexibility and locks you into a fixed income that doesn't grow. A common approach is to use an annuity to cover essential expenses and keep other savings for emergencies, growth, and the things you want to do in retirement.