Annuities: The Good, The Bad, and The Ugly
You’ve likely encountered “the A word”: annuities. And depending on who you talked to, you either heard they’re the greatest thing since sliced bread or the worst financial product ever created.
The truth? Neither extreme is accurate.
Annuities are tools. Nothing more, nothing less. Like any tool, they can be incredibly useful in the right situation or completely inappropriate in another. The challenge is cutting through the noise to understand when they actually make sense.
What is an Annuity, Anyway?
There are many different types of annuities. For this article, we’ll focus mainly on income annuities.
Income annuities function similar to a private pension. If you don’t have a pension through your job, you can buy one with an income annuity.
The way it works is you give an insurance company a lump sum of money, and in exchange, they promise to pay you a guaranteed income stream for a specified period – often for the rest of your life.
Think of it this way: Social Security is essentially a government-run annuity. You pay into it during your working years, and it pays you a monthly income for life once you retire. Income annuities work the same way, except they’re provided by private insurance companies instead of an employer or Uncle Sam.
Types of Annuities: A Quick Overview
Before diving deeper, it helps to understand the basic types of annuities you might encounter:
- Single Premium Immediate Annuities (SPIAs) are the simplest and most straightforward. You hand over a lump sum, and income payments start immediately (typically within a year). These are pure income vehicles with no investment component.
- Deferred Income Annuities (DIAs) work similarly to SPIAs, except the income payments start at a future date you specify – often 5, 10, or 15 years down the road. Because the insurance company has more time before payments begin, DIAs typically offer higher income rates than SPIAs for the same premium.
- Fixed Index Annuities (FIAs) are more complex. Your returns are linked to a market index (like the S&P 500), but with caps, floors, and complicated crediting methods. They’re marketed as giving you market upside with downside protection, but the reality is often disappointing returns with high fees and surrender charges.
- Variable Annuities (VAs) are essentially mutual fund portfolios wrapped in an insurance contract. They offer various investment options and often include optional riders for guaranteed minimum income or death benefits. These tend to be the most expensive annuities, with layered fees that can exceed 3% annually.
For most retirees, the simple income annuities (SPIAs and DIAs) make the most sense if an annuity is appropriate at all. FIAs are hit-or-miss, depending on the issuer and the product. More complex products like Variable Annuities often create more problems than they solve.
The Good: Advantages of Annuities
Let’s start with the legitimate benefits, because they’re real and meaningful for the right person.
Lifetime Income You Can’t Outlive
The primary value of an annuity is longevity protection. When you annuitize a portion of your savings, you transfer the risk of outliving your money to an insurance company. No matter how long you live – whether to 85 or 105 – those checks keep coming.
This matters because one of the biggest risks in retirement is running out of money. We’re living longer than previous generations, and a 30+ year retirement is increasingly common. An annuity can provide a floor of guaranteed income that covers your essential expenses, no matter what happens in the markets or how long you live.
Permission to Actually Enjoy Your Money
Here’s something that doesn’t get talked about enough, but it might be the most important benefit of annuities: retirees with guaranteed income sources actually spend more freely and enjoy retirement more than those relying solely on investment portfolios.
Research by David Blanchett on what he calls “A License to Spend” reveals something fascinating: retirees with pensions or annuities spend substantially more than those without, even when their total wealth is identical. We’re not talking about a small difference here. The psychological comfort of guaranteed income fundamentally changes how people experience retirement.
This ties directly back to our Dark Side of 7 Saturdays a Week post about retirement spending challenges. Many retirees struggle with the transition from accumulation to decumulation. They’ve spent 30+ years in “save mode,” watching their accounts grow, feeling good when the balance goes up and anxious when it goes down. Then suddenly, they’re supposed to flip a switch and start drawing it down. That shift is psychologically brutal.
The result? Many people end up severely underspending – living like paupers despite having ample resources. They leave behind millions, having denied themselves experiences and quality of life improvements they could easily have afforded. They never gave themselves permission to actually enjoy (or give) their money.
An annuity can help solve this problem. When a portion of your retirement income is contractually guaranteed and shows up automatically each month, it feels more like the paycheck you received during your working years. You’re not agonizing over every withdrawal from your portfolio or second-guessing whether you can afford to take that trip. The income is there, and you can spend it.
This behavioral benefit is hard to quantify in a spreadsheet, but it’s absolutely real. If guaranteed income means you actually live the retirement you saved for instead of hoarding money out of fear, that’s enormously valuable – even if it doesn’t show up in an IRR calculation.
Increasing Your Safe Spending Rate
Let’s look at a practical example. Suppose you’re 65 years old with $1 million in retirement savings. Using a conservative 4% withdrawal rate, you might feel comfortable spending $40,000 per year from your portfolio.
Now imagine taking $300,000 of that million and purchasing a lifetime income annuity. That $300,000 might generate $18,000 per year in guaranteed income. Your remaining $700,000 portfolio can now support an additional $28,000 in withdrawals at 4% ($700,000 × 4% = $28,000).
Total annual income: $46,000 ($18,000 from the annuity + $28,000 from portfolio withdrawals). That’s 15% more spending than you’d have without the annuity, and $18,000 of it is guaranteed for life regardless of market conditions.
Even better, because a portion of your income is guaranteed and you’re not dependent on your portfolio for 100% of your spending, your plan is more resilient against market downturns. You’re less likely to need to trim spending in the case of a severe market event.
How Annuities Work with Dynamic Withdrawal Strategies
At 7 Saturdays Financial, we use a planning approach called “guardrails” to manage retirement income. This strategy adjusts portfolio withdrawals up or down based on market performance, helping retirees avoid both underspending in good times and overspending in bad times.
Annuities can enhance this approach. When you have a floor of guaranteed income covering your essential expenses, your investment portfolio only needs to fund discretionary spending. This creates more flexibility in how aggressively you manage those investments.
For example, if $80,000 in annuity income covers your baseline needs, your portfolio withdrawals can be purely for travel, hobbies, giving, and other things that bring you joy. During a market downturn, you can reduce those discretionary expenses, if needed, without threatening your core lifestyle. During strong market periods, you can increase spending with confidence, knowing your essentials are already covered.
This combination – guaranteed income for the floor, dynamic withdrawals for everything else – often produces better outcomes than either approach alone. You get stability where you need it and flexibility where you can use it.
The Bad: Drawbacks of Annuities
Annuities aren’t perfect, and there are legitimate downsides to consider.
Lack of Inflation Protection
Most income annuities provide a fixed payment that doesn’t increase over time. If you purchase an annuity at 65 that pays $2,000 per month, you’ll likely still be receiving $2,000 per month when you’re 85… but that $2,000 will buy considerably less.
You can purchase inflation-adjusted annuities, but they come at a steep cost. The starting payment is typically 30-40% lower than a fixed annuity, and it takes many years for the inflation adjustments to catch up.
For many people, this trade-off doesn’t make sense. They’d rather have the higher initial payment early in retirement, when they expect to be spending more on travel and experiences. They recognize inflation will slowly erode the annuity payments, and choose to manage inflation risk by investing their rest of their portfolio heavily in assets that historically beat inflation (like stocks).
As mentioned before, adding an annuity often means you can take more risk (and expect more growth) from the remainder of your portfolio.
Reduced Legacy for Heirs
When you purchase a lifetime annuity, you’re essentially making a bet with the insurance company about how long you’ll live. If you die early, the insurance company wins. If you live a long time, you win.
This means annuities are generally a poor choice if leaving behind as much as possible is a top priority. The money you invest in an annuity won’t be available to pass on to your children or grandchildren (unless you purchase specific riders that reduce your income payments).
Compare this to keeping money invested in a portfolio. If you leave behind $500,000 in your investment account, your heirs inherit it. If you’d used that $500,000 to buy an annuity, your heirs aren’t likely to receive any proceeds.
That said, annuities with period-certain features or joint-life options can provide some death benefit protection, though these features reduce your monthly income.
Loss of Liquidity and Flexibility
Once you annuitize, that decision is typically irreversible. You can’t change your mind and get your lump sum back if circumstances change or if a better opportunity comes along. And if you can, there are hefty surrender penalties.
This lack of flexibility can be problematic. What if you need a large sum for a medical emergency? What if long-term care becomes necessary? The money is locked in.
This is why annuities should generally only be purchased with a portion of your retirement savings, not all of it. You need to maintain adequate liquid reserves for unexpected needs and opportunities.
Interest Rate Environment Matters
Annuity payouts are directly affected by prevailing interest rates. When rates are low, the income you’ll receive from an annuity is also low. When rates are higher, annuity payouts are more attractive.
This means timing can matter. If interest rates are at historic lows, you might be better off waiting for a more favorable environment rather than locking in a mediocre payout rate for life. Conversely, if rates are elevated, it might be an opportune time to consider an annuity.
The challenge is that nobody knows where rates are headed. But it’s worth being aware that the same $500,000 might generate $35,000 per year in one interest rate environment and $50,000 in another.
The Ugly: How the Annuity Industry Got Its Reputation
Now we get to the really frustrating part. Many of the problems with annuities aren’t inherent to the products themselves, they’re the result of how they’re sold.
The annuity industry has a terrible reputation, and it’s entirely self-inflicted. The industry has spent decades prioritizing sales commissions over client outcomes, and the chickens have come home to roost.
The Commission Problem
Here’s the uncomfortable truth: annuities are often pushed aggressively because they pay sizeable commissions to salespeople.
A typical variable annuity might pay the selling agent a 6-7% commission. On a $500,000 sale, that’s $30,000-$35,000 in the salesperson’s pocket. Even “simpler” fixed-index annuities often pay 5-6% commissions.
With that kind of money at stake, is the salesperson really providing objective advice about whether an annuity is right for you? Or are they motivated by the fat commission check?
As Charlie Munger famously said:
“Show me the incentive and I’ll show you the outcome.”
This is why you should be highly skeptical of annuity recommendations from anyone who earns a commission from selling them. The advice you want should come from someone who doesn’t earn money when you buy an annuity. A fee-only advisor who’s compensated the same regardless of whether or not you purchase an annuity is in a much better position to give objective guidance.
Overselling to the Wrong People
Because of these large commissions, annuities are frequently sold to people who have no business owning them.
Young professionals in their 30s and 40s are pitched variable annuities as retirement savings vehicles, despite having decades until retirement and no need for income guarantees. These products typically come with high fees that drag on returns, surrender charges, and tax complications that make them inferior to simply investing in low-cost index funds within a 401(k) or IRA.
The pitch usually focuses on guarantees and “protected growth” while glossing over the high costs and restricted access to your money. For someone who won’t need retirement income for 25+ years, these features are solutions in search of a problem.
Unnecessarily Complicated Products
The annuity industry has a nasty habit of creating Byzantine products that are nearly impossible for regular people to understand.
Variable annuities with living benefit riders, indexed annuities with complex crediting formulas, and products with more moving parts than a Swiss watch – these complicated structures aren’t designed for your benefit. They’re designed to confuse you and make it difficult to comparison shop or understand what you’re actually paying in fees.
When a financial product requires a 50-page prospectus filled with jargon to explain how it works, that’s a red flag.
The most useful annuities are actually the simplest ones: single-premium immediate annuities (SPIAs) or deferred income annuities (DIAs) that provide straightforward, guaranteed income. No bells and whistles, no complicated riders, just a simple exchange of a lump sum for lifetime income.
Confusing Insurance with Investment
Another source of frustration is the tendency to compare annuity “returns” to investment returns, which is comparing apples to oranges.
An annuity isn’t an investment – it’s insurance against longevity risk. You wouldn’t compare the “return” on your homeowner’s insurance policy to your stock portfolio, yet people do this all the time with annuities.
If you live to 95, the internal rate of return on your annuity might look great. If you die at 70, it might look terrible. But that’s not the point. The point is transferring the risk of outliving your money to an insurance company and guaranteeing those retirement paychecks.
You’ll probably end up wealthier if you keep everything invested in a diversified portfolio instead of buying life insurance or an annuity. But you’re also taking on risks that insurance products eliminate. The question isn’t which has better “returns”, it’s whether the insurance value and other benefits justify the cost for your specific situation.
The “Annuities Are Always Bad” Crowd
To be fair, the ugliness goes both ways. The annuity industry has created such a credibility problem that many financial advisors reflexively reject all annuities as terrible products, even when they might genuinely be the best tool for the job. Incentives can come into play here as well. If an advisor is compensated based on the size of your portfolio, they may be hesitant to recommend you take a big chunk of money out of that portfolio to buy an annuity.
Anyone who says they “always” or “never” recommend annuities is showing their bias. Competent planning requires nuanced thinking about when different tools are appropriate. Sometimes annuities make sense. Often they don’t. The answer depends entirely on the individual’s situation and goals.
When Do Annuities Actually Make Sense?
After all that, you’re probably wondering: when should a retiree consider an annuity?
Here are the situations where these products can be genuinely useful:
- You’re worried about outliving your money. If longevity risk keeps you up at night and you want protection against running out of funds, allocating a portion of your savings to an income annuity can provide peace of mind that’s hard to get any other way.
- You struggle with spending in retirement. If you’re the type of person who has trouble giving yourself permission to spend money you’ve accumulated, the guaranteed income from an annuity can help. As we discussed earlier, people with pension-like income tend to enjoy retirement more and actually use their money.
- You want to optimize your withdrawal strategy. For some retirees, combining guaranteed annuity income with a more aggressive investment portfolio for remaining assets can actually increase total spending capacity while reducing overall risk. This requires sophisticated planning, but it can be powerful.
- You have minimal guaranteed income. If you won’t have a pension and Social Security will only cover a small portion of your expenses, an annuity can help fill that gap and provide a stable income floor.
Conversely, annuities are usually less favorable if you have substantial guaranteed income already (large pension and/or significant Social Security benefits), you want to leave behind as much as possible, you might need access to the funds for unexpected expenses, or you’re being pitched an annuity primarily because someone earns a commission from selling it to you.
A Note on Taxes
One final consideration: how annuity income is taxed depends on where the money came from.
If you purchase an annuity with funds from a traditional IRA or 401(k), the entire income payment is taxed as ordinary income – just like any other distribution from a pre-tax retirement account.
If you purchase an annuity with after-tax money (from a regular brokerage account or savings), only a portion of each payment is taxable. The IRS uses something called an “exclusion ratio” to determine how much of each payment represents return of your principal (not taxed) versus earnings (taxed as ordinary income).
This tax treatment can actually make non-qualified annuities more tax-efficient than fully taxable income from bonds or CDs, since a portion of each payment is considered return of principal.
The Bottom Line
Annuities are neither the villain that some make them out to be nor the miracle solution that salespeople claim.
They’re tools. Sometimes useful, often not, and occasionally absolutely perfect for a specific situation.
The key is approaching them with clear eyes and asking the right questions:
- Does this genuinely solve a problem I have?
- Am I getting objective advice from someone who isn’t financially motivated to sell me on (or steer me away from) this product?
- Do I understand exactly what I’m getting and what I’m giving up?
If you can answer yes to those questions, an annuity might make sense. If not, there are probably better options for your situation.
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About the author: Allen Mueller, CFA, CFP®, is an “engineer turned finance nerd” and founder of 7 Saturdays Financial, a wealth management firm based in Dallas, Texas.
The core focus of 7 Saturdays Financial is helping high performers retire with confidence and make the most of their 7 Saturdays a week.
