Annuity Types

What is an Annuity?

To many people, the concept of an annuity seems complicated. Even the word “annuity” can sound intimidating, like something from a long-ago math class (which is not pleasant if you didn’t enjoy math in school). In this guide, we explain what annuities are, the different types of annuities and their key benefits.

Let’s keep it simple.

Annuities don’t have to be complicated. At the core, an annuity is a series of guaranteed payments made at regular intervals for a specified number of years, or for the rest of your life.

That’s it! That’s the basic concept behind all annuities.

There are choices to make about how long the payments will continue, how frequently they will be made, and whether the payments will be a fixed amount or will fluctuate based on the behavior of various investments. Those things affect how much the annuity costs. But at the core, an annuity is a contract in which the seller promises to deliver to the buyer (the “annuity holder”) a series of regular payments for many years.

That promise is critically important, of course. The seller making the promise is an insurance company. That company invests the money paid by the annuity holder so that it generates a return that is large enough to make the agreed-upon payments for the agreed-upon period of time, which could be 20 years or longer.

It is extremely important to know that with annuities, taxes are deferred until you start receiving payments. The earnings (but not the original amount invested) are taxed as ordinary income when distributed, and may be subject to a 10% penalty if withdrawals begin before age 591⁄2.

How do annuities work?

The simple answer: select an insurance company, agree upon the terms of your annuity, pay the upfront cost, and receive payments beginning on the start date that you choose. But, how do you know an insurance company will be able to make those payments, and how does the company decide how much the annuity should cost?

Remember that math class mentioned earlier? There is a math formula you can use computes the value, or price, of a basic annuity today. The formula shows exactly how the price of an annuity – the amount you would have to pay today – is based on:

  • the amount of the ongoing payments,
  • when the payments will begin (now or at some point in the future)
  • how often those payments will be made (monthly, quarterly, or annually)
  • how long the payments will last (5 years? 10 years? 20 years? For the rest of your life?)
  • the return (the interest rate) the money you pay upfront must earn over the life of the annuity to make all of the payments.

Insurance companies use this formula to figure out what it will cost them to provide the guaranteed payments under the annuity contract. That means each insurance company has to make assumptions about the returns it can earn on various investments over the number of years your annuity will last. This formula can be flipped around to calculate the maximum payments an annuity could make, based on how much is invested today and the other things listed above.

How can an insurance companies promise to make payments for the rest of your life when they don’t know how long you will live?


Many annuities offer some amount of guaranteed income for life. How do insurance companies do that, when they can’t know how long you will live? Using data gathered across different populations and over long periods of time, insurers estimate how long a person of your age is likely to live.


The insurance company knows that some people will not live as long as this estimate, so the total annuity payments made to those people will be less than originally expected. Other people will live longer, so the total payments made to them will be more than originally expected. The company is accepting the risk that those two things will offset each other, so that the total funds available to make all of payments under all of their annuity contracts is sufficient.


As you would expect, an annuity that continues until the annuity holder dies costs more than an annuity that lasts for a pre-specified number of years, because of the risk the insurance company is taking.

Why use annuities for retirement income?

Annuities are tax-deferred investments specifically designed for retirement. 100% of the money in an annuity keeps working for you, year after year, until you start withdrawals. With a regular brokerage account, you pay taxes on your investment returns every year.

This graph shows how the tax-deferral an annuity offers can make a big difference over time. The longer your money is invested tax-deferred, the bigger the benefit. And unlike 401(k)s and IRAs, you can wait as long as you like to start taking withdrawals from an annuity.

The earlier you invest, the more the tax-deferral will work for you.

The Rule of 72

Another way to look at this uses something called the “Rule of 72”. This is a quick way to estimate how long it will take an investment to double, given the rate of return on the investment. To use the Rule of 72, simply divide 72 by the rate of return the investment earns. Here is an example:

Investor A puts $100,000 into a safe, reliable fund of high quality bonds that is expected to return 4% per year. NOTE: in reality, no investment fund can promise any specific return, and the actual return will vary from year to year. This is only for the purpose of this example. Investor A is in the 25% taxes bracket (combined federal and state taxes). That means the amount Investor A has invested grows at 3% per year, not 4%, because 25% of the return is taken out of the fund every year, to pay taxes.

The Rule of 72 says it will take approximately 24 years for Investor A’s money to double in value, to $200,000, because 72 ÷ 3 = 24.

Compare that to Investor B, who puts $100,000 into an annuity that has a 4% rate of return. Since annuities are tax-deferred, the investment grows at the full 4% per year. Based on the Rule of 72, it will take only 18 years for Investor B’s money to double, since 72 ÷ 4 = 18. That means Investor B reaches $200,000 six years faster than Investor A.

Of course, Investor B will have to pay taxes on the investment returns when he or she starts withdrawing money from the annuity, but since that would be after the investor has retired, he or she may very well be in a lower tax bracket.

Types of annuities

Next, we describe the different types of annuities. There are three main categories: Fixed Annuities, Variable Annuities and Indexed Annuities. All of them offer tax-deferred savings for retirement.

What is a fixed annuity?

As we have been discussing, an annuity makes payments for a specified term, or for the rest of the annuity holder’s life. With a Fixed Annuity, those payments stay the same, no matter what happens to interest rates or the stock market. Married couples can buy an annuity where the payments continue to the surviving spouse after the annuity holder dies. This is called a Joint Life with Survivor Annuity. An advantage of this type of annuity is the security of knowing the annuity payments will continue after the first spouse passes. Since there is more uncertainty about how long the annuity will have to last, a joint life with survivor annuity is more expensive than a standard fixed annuity.

What is a variable annuity?

A variable annuity allows you specify how the funds for your annuity are invested over time, by choosing from a selection of investments – typically mutual funds and ETFs. The payments you ultimately receive from the annuity in retirement are determined by the performance of the investments you selected, with some guaranteed minimum. So, a variable annuity allows you to earn the returns offered by the stock and bond markets. The insurance company is bearing the risk that the return on your chosen investments might not be sufficient to cover the minimum payment it has guaranteed. Because of this risk, variable annuities involve higher fees than fixed annuities.

What is an indexed annuity?

With an indexed annuity, the amount you have invested is “credited” with a portion of the return on an equity index – typically the S&P 500, which captures the returns on the stocks of large U.S. corporations. For example, an annuity might be credited with 75% of the return on the S&P 500 index. An indexed annuity includes a guarantee that the annuity holder will not lose any principal, a risk you face when investing directly in the stock market. Indexed annuities offer the opportunity to earn more than a fixed annuity, but less than you would earn from buying an index fund. The return is more stable than the return on the underlying index – both the upside potential and downside risks are lower than a direct investment in the index that does not protect from loss of principal.

This chart shows how each dollar invested in an indexed annuity that returns 75% of the S&P 500’s return would have grown over the 30-year period from the beginning of 1990 to the end of 2018. While overall growth is lower than the return of the index itself, the down-turns experienced in the early 2000’s and in 2008 are less severe.

Who Buys Annuities?

Saving money for retirement, starting early in your adult life if possible, is the best way to get on the right path to being financially secure when it is time to retire. Annuities offer the benefit of tax-deferral that, as shown above, can make a big difference in returns over the years. Even if you are near or at the point of retiring, annuities can be a great way to ensure you have enough guaranteed income to support the lifestyle you want in retirement. Here are just a few scenarios where an annuity can be a good fit within an overall retirement savings plan.

1. Lets Meet Ben

Ben is 40-years old and manages the IT department of a mid-sized company. He contributes the maximum amount to his company’s 401(k) plan every year but is interested in saving more for retirement.

He owns a few stocks and some have done well while others have been a disappointment. His gut tells him that isn’t the best way to invest for the long- term, and he doesn’t want to spend time picking stocks because he’s busy with his career and family. He wants to earn a decent return on his investments and is willing to take some risk to do that.

woman in shallow focus while smiling

2. Lets Meet Alicia

Alicia is 50 years old and owns a small business. While she is definitely not ready to retire yet, she recently started putting money into a retirement account through her business (a SEP IRA) but realizes she needs to save more, because the combination of her projected social security benefits and the amounts she can contribute annually to an IRA won’t be enough to meet her retirement lifestyle goals. She is also a bit concerned about the possibility that social security benefits will be cut in the future, and wants some additional guaranteed income after she does retire.

selective focus photography of coupe

3. Lets Meet Robert and Anna

Robert and Anna are a few years away from retirement.Anna has a pension as a school teacher, but Robert, a professional photographer,does not have any retirement savings other than social security and a small amount he put into a Roth IRA.Robert has been investing most of his other savings in the stock market for many years. He is now thinking about how to reduce the risk of a big market downturn, as that money will be an important source of income for their retirement.

Annuities versus other types of investments

Just like other types of investments, annuities can range from ultra-conservative, with no exposure to the ups and downs of the stock market, to fairly aggressive, offering many ways to participate in the stock market’s growth, or somewhere in between. All annuities – whether fixed, variable or indexed – offer the advantage of letting you defer taxes on your investment earnings until you start receiving payments from the annuity.

They also allow you to decide when to start receiving those payments, any time beginning at age 59 1⁄2 (penalties apply if you take withdrawals earlier).

Let’s face it – making investment choices can be confusing and time-consuming. With an annuity, you “set it and forget it”. The most conservative option is a fixed annuity, which is not tied to the performance of the stock or bond market. A variable annuity provides a minimum guaranteed return while allowing you to participate in the markets through mutual funds and ETFs that reflect your long-term goals and your tolerance for market swings. An indexed annuity gives you exposure to the stock market along with principal protection.

Is an Annuity right for you?

You may not have given it much thought, but when you are retired it’s up to you to decide when and how much to withdraw from your accounts, and how to keep the remaining money invested so that you don’t outlive your savings. Here are some ways an annuity can address this uncertainty:

  • Having an annuity is like setting up your own pension plan. If you have a pension from your workplace, you know it is a regular amount that is paid to you for the rest of your life. A fixed annuity can provide that type of guarantee. If your expenses in retirement are less than you originally expected, use your annuity payments plus social security to cover your retirement expenses and leave your other savings to your children, grandchildren, and to causes you support.

  • An annuity can be an alternative to buying long-term care insurance. Many people hesitate to buy long-term care insurance because of the risk that you might not ever need it. Instead, you could buy an annuity that could be use to pay some or all of the cost of living in a long-term care facility. If you end up not needing long-term care, you use the money from the annuity for something else.

  • An annuity helps to address “longevity risk”. No matter how accurately you are able to predict your expenses after retirement, you don’t know how many years you’ll be retired. People are living longer – if you make it to age 65 in the U.S., males should expect to live another 18 years (on average) and women should plan on living to age 85 1⁄2. An annuity with guaranteed lifetime income will be there if you need it.

Top Five Reasons to Buy an Annuity


Let’s summarize the key benefits of annuities: 


  • Tax advantages – annuities are designed as tax deferred retirement savings vehicles. You pay no taxes on the returns your annuity earns until you start taking withdrawals. Since many people are in a lower tax bracket after they retire, the taxes you will owe on the annuity’s payouts could be lower than the taxes you would have paid on returns generated in a taxable investment account during your working years, when you are in a higher tax bracket.

  • No contribution limits – You can put as much money into an annuity as you like. Many people choose to put a significant portion of their savings into their annuity, which is not possible with other retirements savings options such as 401(k)s and IRAs.

  • No required minimum distribution – Other retirement savings options, such as 401(k) Plans and traditional IRAs, require you to take minimum distributions after you reach a certain age. This can push you into a higher tax bracket, even if you don’t need the money. Annuities allow you to choose the start date for withdrawals, based on your needs.

  • Regular income with investment options – Annuities provide a regular income stream, much like social security, that you can depend on. If you want, an annuity can combine a guaranteed minimum payment with some exposure to market returns. No other retirement savings plan can provide that.

  • Peace of mind – When it is time for you to retire, whether that’s a year from now, 30 years from now, or somewhere in between, you’ll want enough income to meet your lifestyle goals. There’s nothing like the peace of mind that comes with knowing that annuity is there to generate that regular income for you.

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