What Is an Annuity? A Simple Guide for Retirees

An annuity is an insurance contract between you and an insurance company. You pay the insurance company a premium (either a lump sum or a series of payments), and in return, the insurance company agrees to make periodic payments to you, either immediately or at some point in the future.^[1]

Annuities are designed to address one of the biggest concerns in retirement: the risk of outliving your money. According to the Employee Benefit Research Institute, retirees who have a source of guaranteed income report significantly higher confidence in their financial security.^[2]

It is important to understand that annuities are insurance products, not bank deposits or securities. They are not insured by the FDIC or any federal agency. Instead, annuity guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company, with additional protection from state guaranty associations up to certain limits.^[3]

The basic mechanics of an annuity involve two phases. During the accumulation phase, your money grows on a tax-deferred basis inside the contract. This means you do not pay taxes on the growth until you begin taking withdrawals, which can allow your money to compound more efficiently over time.^[1]

During the distribution phase (also called annuitization), the insurance company begins making payments to you. These payments can last for a set number of years or for the rest of your life, depending on the contract you choose.

One of the key advantages of annuities is their ability to provide lifetime income. Unlike a bank account or brokerage account that can be depleted, an annuity with a lifetime income option will continue making payments as long as you live, regardless of how long that may be.

There are several types of annuities, each designed for different financial goals and risk tolerances.

Fixed Annuities (MYGAs) offer a guaranteed interest rate for a set period, typically 3 to 10 years. Your principal is protected and your rate is locked in regardless of market conditions. These are among the simplest annuity products available.^[4]

Fixed Indexed Annuities (FIAs) offer interest that is linked to the performance of a market index, such as the S&P 500, but with a 0% floor. This means your account value can increase when the index goes up, but it will not decrease when the index goes down. FIAs typically include caps, participation rates, or spreads that limit the maximum interest credited.^[4]

Income Annuities (SPIAs and DIAs) are designed to convert a lump sum into a stream of guaranteed payments. A Single Premium Immediate Annuity (SPIA) begins payments within a year of purchase. A Deferred Income Annuity (DIA) begins payments at a future date you select.

Annuities are not the right fit for everyone. They tend to work best for people who are approaching or already in retirement and want to create a reliable income stream that they cannot outlive.

An annuity may be a good fit if you have already maximized your other tax-advantaged accounts, you want to reduce your exposure to market volatility, or you are looking for a way to create pension-like income in retirement.

An annuity may not be the best choice if you need full liquidity for your savings, you are in a low tax bracket and do not benefit from tax deferral, or you have a short time horizon.

The best way to determine if an annuity is right for your situation is to speak with a qualified advisor who can evaluate your complete financial picture and help you understand how an annuity fits within your overall retirement plan.