I was having coffee with a caveman the other day and the question came up: What’s an annuity?

I took a deep breath, then eased into the explanation I’ve rehearsed over the years. I first laid this concept on a group of financial advisor trainees at a large investment company I worked for. Many of them had negative attitudes about annuities and the rest didn’t know enough about annuities to have an opinion. I figured, what the heck, if I can help that audience understand annuities, I might be able to get through to a caveman too.

My chat with a caveman about annuities

Me: Imagine you just won a $30 million lottery prize and they ask you if you want the money in a lump sum or spread over the next 20 years. Which would you choose?

Caveman: Sound’s like a trick. What’s the catch?

Me: Before you decide, you need to know this: if you choose a lump sum, you’ll only get $25 million dollars. Plus, you’ll have to pay taxes on that.

Caveman: What if I take the payments over 20 years?

Me: Then you’ll get the full $30 million. You still have to pay taxes.

Caveman: No brainer, bruh. I want the payments over 20 years.

Me: Okay, so you want the annuity.

Caveman: Annuity? Heck no, I want my lottery winnings paid over 20 years so I get the whole amount. And by the way, what’s an annuity?

In a nutshell, an annuity is nothing more than a series of payments over a number of years.

If you’re still with me, congrats! Now you know what an annuity is. In a nutshell, an annuity is nothing more than a series of payments over a number of years. Why people make it more difficult than that is beyond me.

How insurance companies have complicated annuities

Annuities are technically insurance products, backed by life insurance companies. That’s because some assurances are made as to how much your beneficiary might receive upon your death. (Another topic for another day.)

When annuities began to lose some of their appeal, insurance companies started loading up their annuity products up with all sorts of features and fancy names to make them more marketable. In the process, they alienated potential clients and spawned a pool of critics. Annuities are far less confusing, though, if you just step back and remember that, at their core, all annuities have the same basic objective: to provide income.

All annuities have the same basic objective: to provide income.

Types of annuities

  • Immediate: Begins making income payments right away.
  • Deferred: Payments begin at a later date, allowing your investment (premium) the potential to grow.

Investment options

  • Fixed: Guarantees your principal (premium) will grow at a minimum set rate; sometimes higher.
  • Variable: You can choose to invest your premium in one or more “subaccounts” made up of stock or bond investments – or both.

With most annuity providers, you can mix and match these features. In other words, whether you choose an immediate or deferred annuity, you can choose whether you want your investment dollars to have a fixed rate or variable return.

Why annuities get a bad rap

It’s rare to find a piece in financial publications or websites that has anything glowing to say about annuities. The main issue that most critics have with annuities is the fees. One mutual fund company I worked for actually provided us with talking points of all the bad things about annuities when a client asked if we offered them. With all the negative press, it’s actually hard to believe that people still make a living selling annuities.

Annuities can have lots of fees. To the untrained eye, the fees may be hard to spot. That’s because they’re not presented as one amount. And they’re technically not all “fees.” They go by a variety of names, so let’s just call them expenses.

Expenses commonly charged for annuities:

  • Surrender charge
  • Mortality expense
  • Administration fee
  • Transaction fee

My take is that if you are interested in an annuity offered by a trustworthy provider (agent and company), the fees shouldn’t hold you back. Most of the fees are in place to help the provider recoup their costs if you don’t live up to your end of the agreement. And by that I mean you take your money and run before the term you signed up for is over.

The key to not taking a bath in fees is to only invest in an annuity if you can ride out the full contract period.

Are annuities just for retirement?

Annuities are best suited for supplementing retirement income; however, they can be used for other purposes too – such as paying out lottery winnings.

One of the key advantages of most annuity products is tax deferral. If you put money into an annuity, generally you pay no taxes on it from year to year if it grows in value. Eventually, you pay taxes on any amount you take out above what you put in.

The flip side is that if you pull money out before the age of 59-1/2, you owe the IRS a 10% penalty. That’s why annuities happen to be of greatest benefit to people who have reached retirement age.

Keep in mind that annuities were a thing well before 401(k) retirement plans and IRAs came along. Once upon a time they were the best thing around for people to put away money for retirement.

Is an annuity right for me?

I wouldn’t think of telling anybody whether an annuity is right for them without knowing their complete financial picture. Suffice it to say, annuities are right for some people.

Here is how I would describe the ideal prospect for an annuity product:

  • Either has no earned income or has earned income and has maxed out their 401(k) at work and IRA or Roth IRA
  • Wants annuity income payments to start right away or won’t need the money for at least the length of the contract term (usually five years or more)
  • Currently over the age of 59-1/2 or will be when the contract term ends
  • Likes the idea of having additional income paid to them (or surviving spouse)

If you cannot say yes to all of the bullets above, you should probably stay away from annuities.

If you’re still on the fence and leaning towards getting an annuity, the most sensible thing you can do is meet with an annuity representative and ask them to run an illustration for you. You’ll get a hypothetical projection of future account values and income payouts to review more closely.

The takeaway

Annuities get a bad rap for the layers of fees that they often charge. Some of those fees don’t apply if you hold the annuity for the agreed upon contract term. If you have already maxed out your other retirement options and are looking for another way to save money on taxes for your retirement savings, an annuity may be worth looking into.


Important: The information provided here is for educational purposes and should not be considered advice. Before you make any final decisions, consult a trustworthy financial professional and/or tax planner.

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