The issue isn’t annuities themselves; it’s when they’re used for the wrong reasons or sold as a universal solution.
If a contractor tried to build an entire home with only a hammer, the result would be a mess. Great outcomes come from using the right tools, at the right time, for the right job.
What is an annuity?
An annuity is best understood through the lens of risk. You’re not eliminating risk—you’re transferring it from yourself to an insurance company. The question shifts from “Will markets perform?” To – “Is this insurer financially strong enough to honor its guarantees?”
The cons of an annuity
- Illiquid – typically, annuities have a period of time during which you can not access the full amount. Most annuities allow a certain amount to be “surrendered” with no penalty, e.g., 10% of the account value per year. If you withdraw more than 10% of the account value, a penalty may apply to the amount above 10%.
- It can be complex and confusing – a lot of different types can cause confusion and low transparency.
- Difficult to understand the underlying costs
- Tax inefficient for wealth transfer.
The pros of an annuity
- A portion of your portfolio’s risk resides with an insurance company – you are outsourcing the risk of a portion of your portfolio to an insurance company.
- There is a guarantee that you’ve contracted for with the insurance company, whether it’s an income stream, downside market protection, guaranteed growth rate, etc.
- Can act like a pension for income in your retirement
- Can be used as another layer of diversification in addition to a stock/bond portfolio
Annuitization
To understand why annuities have earned their reputation, look to annuitization. When you annuitize an asset, you give up control of the principal in exchange for predictable, contractual income.
Annuitization is the process of converting accumulated annuity funds into a series of regular income payments for a set period or the annuitant’s lifetime. Once an annuity is annuitized, the contract generally enters an “annuity phase,” in which most or all of the cash value is replaced by guaranteed income payments under the selected payout option (single life, joint life, period-certain, etc.).
In the past, annuitizing was the only way to receive a guaranteed income. The decision was irrevocable, and if you died early, the insurance company often kept the remaining value. Although many people value the guarantees, they dislike the loss of flexibility and legacy.
While some people still choose to annuitize assets for income, we don’t see it as much as we used to, because there are other options for receiving guaranteed income without annuitizing. Some annuity types are designed primarily for accumulation and protection rather than for income, such as fixed annuities and fixed indexed annuities.
Income rider
One way to draw income from an annuity without annuitizing it is through an income rider.
An income rider creates a guaranteed paycheck from an annuity while you still retain ownership and control of the underlying account.
Annuitization vs Income Rider:
Annuitization:
- You give up the lump sum.
- Income is irrevocable
- No remaining account value
Income rider:
- You keep control of the account.
- Income is based on a benefit formula.
- There may be remaining value for beneficiaries.
The main annuity types are fixed, indexed, and variable, with immediate and deferred options. Their fees range from very low (often embedded spreads) to quite high (layered, asset-based charges and riders). Fee transparency and impact are most critical with variable and indexed products, where all-in costs can materially reduce returns over time.
Core annuity types
- Fixed annuity: An insurance company credits a declared interest rate and guarantees principal, often through multi-year guaranteed annuities or fixed deferred contracts. Principal and interest are returned to you at the end of the annuity’s term. You select the term; the longer the term, the higher the declared interest rate.
- Fixed indexed annuity: Crediting is linked to an index with a floor (no market loss) and a cap on upside; the insurer guarantees principal. Principal and growth are returned to you at the end of the term. You select the term, the longer the term, the higher the cap rate (the max upside credit)
- Variable annuity: Account value invested in subaccounts similar to mutual funds; value and income fluctuate with markets, generally offering the highest growth potential and risk.
- Immediate vs. deferred: These are income-focused annuities. Immediate (often SPIA) starts income within 12 months of purchase (pension income today); deferred builds value tax-deferred and turns on income later (pension income later).
Typical fee structures
- Fixed annuities:
- Compensation and company profit are usually built into the interest rate “spread,” so explicit annual fees are often low or not itemized to the client.
- Fixed indexed annuities:
- Many are marketed as “no-fee” because base policy fees are low or not itemized, but the effective cost is driven by participation rates, caps, and spreads that limit the credited interest.
- Optional income riders or death benefit riders can add explicit annual charges (often as a percentage of the benefit base).
- Variable annuities:
- If there is an annuity type responsible for the reputation of annuities having low transparency and high fees, it would probably be the variable annuity.
- Mortality & expense (M&E) risk charges, administrative fees, and underlying fund expenses.
- Optional guarantees (living benefit and enhanced death benefit riders) often include asset-based fees, resulting in total annual costs that are significantly higher than for most mutual funds or ETFs.
Note: Both fixed indexed annuities and variable annuities are not annuities that prioritize income guarantees, but they typically have options to add income riders if you desire guaranteed income now or in the future. Additional fees will be applied if you opt into these income riders.
Immediate vs. deferred fee dynamics
- Immediate annuities (Single Premium Immediate Annuities – “SPIA”):
- Pricing is primarily embedded in payout rates; there is usually no explicit ongoing fee schedule, as the insurer retains the spread between the premium and the promised income.
- The economic “cost” lies in the contract’s irrevocability and lack of liquidity, rather than in itemized fees.
- Deferred annuities:
- Accumulation-phase products (fixed, indexed, variable) all use surrender charges and, for market-linked types, explicit or implicit asset-based fees to recoup commissions and insurer costs.
- Longer surrender schedules and richer riders typically correlate with higher all-in economic cost.
So, are annuities good or bad?
That’s the wrong question.
The better question is: What job are you trying to solve?
Annuities are tools. Some are designed to provide guaranteed lifetime income—essentially replacing or supplementing a pension. Others, such as certain fixed indexed annuities, are not primarily income tools. They are built to provide principal protection with the opportunity for capped, market-linked growth. Very different purposes. Very different outcomes.
Before deciding whether an annuity makes sense, ask yourself:
- Do I want to transfer income risk to an insurance company, or am I comfortable managing market risk myself?
- Am I trying to create a guaranteed paycheck for life, or simply reduce volatility while still pursuing growth?
- Do I understand the difference between income-focused annuities and non-income-focused annuities
- If I need income, do I understand whether the product requires annuitization, or whether an income rider would preserve flexibility?
- How important is liquidity over the next 5–10 years?
- Is leaving a tax-efficient legacy a top priority? Annuities are not tax-efficient legacy tools
- Am I looking for growth, protection, income, or a combination of the three?
If your primary goal is predictable lifetime income, certain annuities can deliver that in a way markets alone cannot.
If your goal is downside protection with measured upside participation, an indexed annuity may serve that role.
If your goal is long-term market growth with full liquidity and transparency, traditional investments (stocks, bonds, ETFs, mutual funds) may be more appropriate.
The issue isn’t whether annuities are good or bad.
It’s whether the specific annuity matches the specific problem you’re solving.
The right tool, for the right job, at the right time.
Any opinions are those of the author and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
Investors should consider the investment objectives, risks, and charges and expenses of variable annuities carefully before investing. The prospectus contains this and other important information about the variable annuity and its underlying funds. Prospectuses for both the variable annuity contract and the underlying funds are available from your financial advisor and should be read carefully before investing.
Variable annuities are long-term investment alternatives designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if made prior to age 59 1/2, may be subject to a 10% federal tax penalty. Early withdrawals may be subject to withdrawal charges. Partial withdrawals may also reduce benefits available under the contract as well as the amount available upon a full surrender. An investment in variable annuities involves risk, including possible loss of principal. The contracts, when redeemed, may be worth more or less than the original investment. Withdrawals from annuities will affect both the account value and the death benefit. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. An annual contingent deferred sales charge (CDSC) may apply.
A fixed annuity is a long-term, tax-deferred insurance contract designed for retirement. It allows you to create a fixed stream of income through a process called annuitization and also provides a fixed rate of return based on the terms of the contract. Fixed annuities have limitations. If you decide to take your money out early, you may face fees called surrender charges. Plus, if you’re not yet 59½, you may also have to pay an additional 10% tax penalty on top of ordinary income taxes. You should also know that a fixed annuity contains guarantees and protections that are subject to the issuing insurance company’s ability to pay for them.
