Primer · Annuities
How Annuities Actually Work.
Four contracts that get lumped into one word. What each one does, what it costs you in access, and why the category argument is the wrong argument.
Almost nobody argues about annuities accurately
Annuities attract stronger opinions than any other financial contract, and most of those opinions are about a product the speaker has not specified. "Annuities are terrible" and "annuities are safe" are both claims about a category containing four quite different instruments with different costs, different guarantees, and different failure modes.
An annuity is not good or bad. It is a contract with an insurer, and fit is the only question worth asking about it.
The gap: money with a job nobody assigned it
The problem an annuity solves is usually one of two things. Either you have money that cannot afford to fall — because you will need it soon, or because falling would change what it supports — or you need income that keeps arriving no matter how long you live.
Neither problem is solved well by a portfolio alone. A portfolio can be sold at the wrong time, and it has no mechanism for guaranteeing income past the point the money runs out. That is the gap, and it is worth naming before anyone shows you a product.
What you are actually buying
In every case you are handing an insurer a sum of money in exchange for a contractual promise: a rate, a floor, an income stream, or some combination. The promise is backed by the insurer's claims-paying ability. It is not FDIC-insured, and it is not a security registered on an exchange.
What you give up is access. Nearly every annuity carries a surrender period during which withdrawing more than a defined amount costs you a penalty, and sometimes a market value adjustment on top. That constraint is the price of the guarantee, and it is the single most common source of regret.
What's at stake
The four contracts, and what separates them
Same category, genuinely different instruments.
Fixed annuity
The insurer declares an interest rate and credits it. Principal does not decline from market movement. The rate can typically be reset after an initial period, subject to a contractual minimum. The simplest of the four, and the easiest to compare against a CD.
MYGA (multi-year guaranteed annuity)
A fixed rate guaranteed for a set term — commonly three to ten years — with tax deferral on growth. It is the closest thing in the category to a CD, with three differences: the tax treatment, the surrender terms, and who stands behind it. Rate certainty, no index-linked upside.
Fixed indexed annuity
Principal is protected from index declines, and interest is credited based on index movement, limited by a cap, a participation rate, or a spread. It does not invest in the index and receives no dividends from it. In a negative crediting period the index-linked interest can be zero, but the decline is not passed through to your principal, subject to contract terms.
Income annuity
You exchange a sum for a defined stream of payments, beginning immediately (a SPIA) or at a chosen future date (a DIA). It solves longevity directly: the payments can be structured to continue for life. In exchange, that money is generally no longer available as a lump sum.
Possible approaches
Where each contract tends to fit
Depending on the situation. Fit is individual, and more than one answer is often defensible.
Income you cannot outlive
An income annuity, or a fixed indexed annuity with an income benefit.
Principal that must not decline
A fixed annuity or a fixed indexed annuity, per contract terms.
A known rate for a known term
A MYGA, compared honestly against CDs and Treasuries of the same maturity.
A lump sum with no immediate job
A shorter MYGA, so the money is positioned without being locked away for a decade.
Tax deferral on after-tax money
A non-qualified annuity, where deferral is the actual benefit being bought.
Reducing sequence-of-returns risk
Protecting the portion you will draw on first, so a bad early year is not compounded.
Leaving a defined amount to a beneficiary
Contracts with death benefit provisions, understanding how they are taxed.
Trade-offs
The trade-offs worth understanding first
None of these are hidden. They are simply skipped.
- Surrender charges apply for a defined period, often six to ten years, and can be substantial early on.
- A market value adjustment may increase or decrease the surrender value depending on interest rate movement.
- Caps, participation rates, and spreads on indexed contracts can be changed by the insurer within contractual limits after the initial period.
- Index-linked interest can be zero in a negative crediting period. Protection from loss is not the same as a guaranteed gain.
- An indexed annuity does not receive index dividends, which is a meaningful part of long-run index return.
- Income riders usually carry an explicit annual fee, and the benefit base they grow is generally not a walk-away value.
- Gains in a non-qualified annuity are taxed as ordinary income on withdrawal, not at capital gains rates, and withdrawals come out gains-first.
- Withdrawals before age 59½ may carry a 10% federal penalty in addition to ordinary income tax.
- Guarantees rest on the claims-paying ability of the issuing insurer. They are not FDIC-insured.
- Putting a tax-deferred contract inside an already tax-deferred IRA adds no tax benefit; if that is the whole rationale, it is not a rationale.
Honest fit
When an annuity is the wrong tool
- You may need the money during the surrender period.
- It would represent the great majority of your liquid assets.
- You are decades from needing income and can tolerate market volatility.
- The only argument offered for it is tax deferral inside an IRA.
- You cannot get a straight answer about the surrender schedule or the rider fee.
- The pitch leads with an illustration rather than with the contract's guarantees.
Questions to ask
Questions to ask before you sign anything
- What is the surrender schedule, year by year, and what is the free withdrawal amount?
- Is there a market value adjustment, and how does it work in both directions?
- What are the cap, participation rate, and spread today, and what are the contractual minimums the insurer could move them to?
- What does this contract guarantee if the index does nothing for ten years?
- What is every fee, stated annually, including any income rider?
- Is the income benefit base a real account value I could walk away with, or only a figure used to calculate income?
- What is the insurer's financial strength rating?
- How are you compensated, and does it differ across the products you could have shown me?
Keep exploring
Related Resources
When you're ready
Compare It Against Doing Nothing.
A review starts with the job the money has, then compares the contract against your alternatives — including leaving it exactly where it is.
Independent · Compared Across Carriers · Implemented Properly
Important disclosures
Educational only. This is not tax, legal, or investment advice, and it is not a recommendation of any product. Annuity guarantees are backed by the financial strength and claims-paying ability of the issuing insurer and are not FDIC-insured. Fixed indexed annuities are not investments in the stock market and are not directly invested in any index; they do not receive index dividends. Withdrawals may be subject to surrender charges, market value adjustments, ordinary income tax, and a 10% federal penalty before age 59½. Product features and rates vary by carrier and state. Consult your own tax and legal professionals.