The word “annuities” can generate a range of reactions from clients, their family members, and their advisors. Some reactions are positive while others are not so much. Everyone, however, can agree that they can be very complex.

That said, sales of annuities were exceptionally strong during 2021 up 16% to $254.8 billion. Some of this growth can be attributed to the strong stock market results which encouraged purchasers to consider riskier but potentially more lucrative variable annuities. Also, the low yields on most fixed income investments made the income from fixed annuities seem relatively more attractive. Finally, the potential for tax deferral was attractive because of concerns about higher rates.

This article will examine these complex vehicles to help provide some solid background information as to why they have appeal for certain individuals but also what drawbacks exist.


An annuity is an insurance contract, not an investment. They can make regular payments to you immediately or at some point in the future. These payments can be for a fixed term or for the lifetime of the individual. Each payment will include both return of principal and some income/gains. Any income earned is deferred from taxation until paid as a distribution. An individual can purchase an annuity via a lump sum or through periodic payments.




Insurance companies have been creative in expanding the types of annuities available to broaden their appeal. The four most common types are as follows:

Fixed Annuities: These annuities are the most conservative variety as they offer a stated rate of interest and provide principal protection. The annuities can be for a specified number of years or for the life of the annuitant. The guaranteed income for life option is one of their biggest attractions for individuals fearful of outliving their retirement assets.

Fixed Index Annuities: These annuities have the potential to earn a higher rate of return than a traditional fixed annuity because a portion of the returns on an underlying index (such as the S&P 500) are credited to your account each year using a specified participation rate. If the participation rate is 60% and the return on the S&P 500 was 10%, 6% would be credited to your annuity account. Most annuities of this type will “cap” the amount of appreciation that they will credit in any one year. But gains are locked in so that you will not lose earnings if the index declines in a subsequent year.

Structured Annuities: These annuities are similar to fixed index annuities but allow for potentially higher upside participation with less downside protection. For example, the upside participation may be set at 100% up to a specified rate of return (such as +10%) but the downside may only partially protect you against any losses up to a specified limit (such as -10%). For example, if the index has a return of 13%, your account would be credited with a maximum of 10%. If the market declines by -13%, your account would decline -3% (-13% less the 10% downside buffer).

Variable Annuities: These annuities are the most investment – oriented but also entail the most risk and complexity. They are structured as deferred annuities with payments to begin at some point in the future. The value of the annuity is based in the performance of underlying mutual funds or exchange-traded funds with no guaranteed return or principal protection. Variable annuities, however, can have a rider or provision allowing for a return of principal (less any withdrawals) as a death benefit.



Four key attributes are often shared by financial advisors when they are encouraging clients to purchase an annuity to achieve “peace of mind” for at least a portion of their wealth.

Cash Flow Stream: A steady stream of payments can be attractive to help supplement pensions and Social Security. Also, many people are fearful about outliving their investment assets.

Tax Deferral: Any gains or income earned is not taxed to the purchaser of the annuity until the payments are received.

Protection Against Downside Volatility of the Investment Markets: This attribute is true for fixed and fixed index annuities, but is less accurate for structured and variable annuities as they are designed to offer the potential for higher returns to the annuitant.

Easy Solution: For people that are uncomfortable managing their retirement assets, annuities represent an easy approach to having someone else handle this responsibility while receiving distributions along the way.


Fees: Financial advisors can receive sales commissions of up to 10% of a contract’s value. Also, to obtain some of the benefits provided by annuities, insurance companies need to charge additional fees for administration, mortality, investment, and distribution expenses. Additional charges can be incurred if a purchaser would like to have principal protection, inflation protection, a long-term care provision, and a lifetime income guarantee. These additional features are referred to as “riders” by the insurance companies. All in, annual fees can total 2% or more per year. Keep in mind that higher fees reduce investment returns.

Liquidity/Surrender Charges: Should a purchaser’s personal circumstances change, it can be difficult or expensive to withdraw assets from an annuity. Most annuities have a surrender charge for any amounts withdrawn in a given year. These surrender charges can be in place for six to eight years, but gradually decline over the life of the contract. Insurance companies employ such surrender charges to protect against excessive withdrawals in any one year. For example, the first year surrender charge may be 10% of the withdrawal amount. In the second year, this charge may be 8% and will decline further in subsequent years.

Withdrawals Before Age 59½ Subject to IRA Penalty: If an individual withdraws funds from a deferred annuity before reaching age 59 ½, the IRS will assess a 10% penalty on any income realized from the withdrawal. This penalty can further complicate the annuitant’s liquidity issues.

Income from Distributions Taxed at Ordinary Rates: Distributions from an annuity are part income and part return of principal if the annuity was purchased with after-tax dollars (rather than in a qualified account like an IRA). The income portion is taxed at ordinary rates even if a portion of this income is from capital gains. Most investors are taxed at capital gains rates of 15% or 20%. Ordinary rates can quickly jump into the 22% bracket and can be as high as 37% at the federal level. This taxation of the income at ordinary rates mutes the tax deferral benefits of annuities.

No Step-Up in Basis at the Date of Death: Unlike a traditional investment portfolio, annuities do not get a step-up in basis to the date of death value. This basis step-up can help to reduce future capital gains for the beneficiaries of the estate.

Pre-Mature Death: If you purchased a fixed annuity with “life only” payments but did not also purchase a death benefit rider, your family may not receive any additional payments such as the balance in the annuity or a guaranteed minimum amount. In this scenario, your pre-mature death could negatively impact the value received from the annuity.


The idea of an annuity simply intrigues some individuals and provides them with some peace of mind. For those individuals, the following guidelines may be appropriate.

Candidly ask the financial advisor selling the annuity to explain the benefits and drawbacks to you in as simple of terms as possible.

Utilize annuities for only a portion of your retirement or investment assets. This helps to avoid some of the liquidity issues that we described earlier and allows for greater diversification with lower fees.

Invest growth assets such as stocks outside of the annuity and use fixed annuities for a portion of the fixed income asset allocation holdings.

Use annuities to complement Social Security benefits in terms of providing a monthly stream of income. This approach may be particularly beneficial if you do not receive pension payments.

Utilize traditional and Roth IRAs instead to generate strong tax deferral benefits without the need for a formal annuity.


Annuities are extremely complex and can be expensive in terms of underlying costs. For some individuals, however, they can play a role within a well-diversified portfolio. It is important to review them in conjunction with a comprehensive wealth management plan including a sustainability analysis of cash flow needs.