Hey, guys. Mike Frontera here, back with another Retirement Theory video. So let’s talk annuities. They’re one of the most misunderstood products in all of retirement planning—so unique in what they can offer, yet subject to so much hate, much of it deserved, by the way. Today I’m going to give you the good, the bad, and the reality about annuities. So buckle up. By the time this video is over, you’re going to know more than 90% of the folks out there about annuities, which will not only be super valuable for your retirement planning—it’ll also make you a hit at your next cocktail party.
So what is an annuity anyway? Let’s start with a little history. The word “annuity” comes from the Latin word annua, meaning yearly. Back in the Roman days, people would give a lump sum of money to the state in exchange for a lifetime series of payments. It was a simple way to create income that couldn’t be outlived. And that’s really what an annuity is: taking a lump sum of money and converting it into an income stream that lasts for a lifetime. Think of it like buying your own pension.
Today, annuities are issued by insurance companies and, in the purest form, work basically the same way. You send an insurance company $100,000 (or whatever sum of money), and about a month later you start receiving a monthly paycheck that lasts as long as you’re around to cash it. That’s known as an immediate annuity because payments start immediately. But interestingly, even though immediate annuities represent the purest form of what an annuity is, they make up only about 3% of total annuity sales today.
So we have immediate annuities on one branch, and on the other branch we have deferred annuities—the vast majority of annuities out there. Deferred simply means you keep your lump sum in its own account and postpone the conversion into a lifetime income stream. While it’s deferred, the money can grow in different ways. You’ll hear terms like variable annuity, indexed annuity, fixed annuity, or registered index-linked annuity (a “RILA”). These simply describe the different ways the money inside the deferred annuity can grow.
Once you’re done deferring, you can convert that sum into a lifetime income stream. That’s called “annuitizing” your contract. At that point, your account value is gone—your lump sum has vanished—and in its place you now have this pension-like stream of income. Many people don’t like that because it feels permanent, and people don’t like that perceived loss of value. As a result, most annuity contracts are never formally annuitized. But that doesn’t mean people aren’t using annuities for income. In fact, it’s the opposite. Many retirees want income they can’t outlive, and modern annuities can provide lifetime income through income or withdrawal riders without requiring you to annuitize.
With that backdrop, let’s talk about what annuities do well. One of the biggest challenges in retirement planning is that we don’t know how long we’re going to live. We’ve got this big chunk of money saved, but we don’t know how long we need it to last. These days most people don’t have a large pension, and if you’ve looked at your Social Security estimate lately, you’ve seen the warnings that the trust fund may be depleted within ten years or less. So not running out of money is understandably a top priority.
The annuity is designed to solve exactly that. They’re the only financial product that can guarantee you’ll never run out of your withdrawals for as long as you live. Insurance companies back that guarantee by using their massive size and something called the law of large numbers. You have one life to worry about, and there’s wide variability in how long that life lasts. But when you evaluate tens or hundreds of thousands of lives, you can predict with surprising accuracy how long people will live on average. Using that average, the insurer can calculate how much to pay. Some people will die earlier and receive less; others will live past the average and receive more. This leads to one of the biggest advantages annuities offer: the longer you live, the more you benefit. These are called “mortality credits.”
In your own retirement portfolio, the longer you live, the more money you consume. If you expect to live a long life, you need to plan for that by saving extra. Annuities solve this longevity risk. For example: if you knew an annuity would cover all your expenses starting at age 80, then suddenly you only need to plan for your portfolio to last until age 79. Or if Social Security plus an annuity covers your basic “must-have” expenses, then maybe you’d feel more comfortable spending from the rest of your portfolio—or investing it more aggressively—knowing your essentials are covered.
So far annuities sound great. So what’s Ken Fisher all bent out of shape about? Let’s talk about the bad.
Taxes fall into both a good and bad category. Annuities are tax-deferred, meaning if you put after-tax money into an annuity, you’re not taxed on growth until you withdraw it, and you can trade internally without creating a taxable event. That’s the good. The bad is that you don’t get capital gains treatment. All gains come out last-in-first-out and are taxed at ordinary income rates. Also, nonqualified (after-tax) annuities don’t get a step-up in basis when someone dies and they are subject to required minimum distributions for beneficiaries. And like IRAs, an annuity has a 59½ early withdrawal penalty on gains.
Next: liquidity. Immediate annuities have no liquidity—you hand over your lump sum, and there’s no undo button. You can’t access the principal at all. Deferred annuities usually allow small free withdrawals (5–10%), but anything above that typically triggers steep penalties and surrender charges that can last for years. To be fair, some people buy annuities solely for their unique accumulation features and don’t care about liquidity. Many fixed annuities offer very competitive rates because large insurers can buy bonds at better pricing than individuals can.
Another issue is complexity. Annuities are extremely difficult to understand. Accumulation-focused annuities have participation rates, caps, spreads, floors, buffers, formulas that look like calculus problems. Income-focused annuities have benefit bases, roll-up rates, step-ups, and strict rules about withdrawals. They can absolutely provide value, but you need to understand what you’re buying and ideally choose contracts with fewer moving parts.
There’s also inflation risk. Most immediate annuity payments are flat. Most income riders are flat as well. Some annuities offer inflation adjustments, but they usually start at a much lower income level and almost none track actual CPI. So yes, you get longevity protection, but you may create an inflation problem. $2,000/month at 65 might feel great—but at 85 it buys much less.
Then there’s what I call “FIR”—fees and investment restrictions. Insurance companies are in the business of making money. When you buy an annuity for lifetime income protection, you’re buying insurance—portfolio insurance, longevity insurance—and you’re paying for it. If you had the exact same investment outside an annuity, it would almost always perform better simply because it’s cheaper. Inside the annuity, you’re paying someone else to take on that longevity risk. And like any insurer, they want to collect the most in fees and pay the least in benefits.
For example: imagine you buy a $100,000 annuity with a 3% annual fee and a 5% lifetime withdrawal rate. Your $5,000 withdrawal each year is just coming out of your own $100,000 until it’s gone. The insurance company only starts paying their own money once your account hits zero. They know how long people live on average and price accordingly. You benefit the most if you live a very long life—especially if the market tanks right when you start taking income (like retiring into 2008). But insurers aren’t fools—they often restrict how aggressive you can invest inside the annuity to reduce the odds they’ll have to pay from their own pocket.
So what’s the reality? Are annuities bad? Are they good? The answer is neither. Annuities are tools designed for a very specific problem. If you have that problem, annuities are uniquely capable of solving it. If you don’t, you’re likely wasting a lot of money.
No investment—not stocks, bonds, or real estate—can guarantee income for life. Annuities can, because they pool longevity risk to make it predictable. If your biggest fear is running out of money in retirement—especially if you don’t have a pension or are worried about Social Security—an annuity can be a prudent part of your plan. But to get that protection, you’ll give up liquidity, flexibility, and some investment control. So understand what you’re getting; if you don’t understand it, keep looking.
And by the way, if the person recommending the annuity only makes money by selling annuities, guess what tool they’ll reach for? As the saying goes, when all you have is a hammer, everything looks like a nail. If your situation calls for lifetime income protection or a conservative way to grow money, an annuity could be the right solution. Otherwise, there are likely better options.