An annuity is an insurance product that converts a lump sum into guaranteed income — often for life. It transfers longevity risk to the insurance company, ensuring you never outlive your income. The trade-off: you give up access to the capital and potential for higher investment returns.
An annuity is a contract with an insurance company where you exchange a lump sum of money for a guaranteed stream of income payments, either immediately or starting at a future date. Annuities are the only financial product that can guarantee income for life, regardless of how long you live or what markets do. They effectively let you create a personal pension using your own savings.
How It Works
The basic transaction:
- You pay a lump sum to an insurance company (e.g., $300,000)
- The insurer calculates a monthly payment based on your age, gender, interest rates, and the type of annuity
- You receive guaranteed income for life (or for a fixed period, depending on the contract)
| Annuity Type | Start | Payment | Best For |
|---|---|---|---|
| Immediate fixed | Now | Fixed dollar amount | Retirees needing income today |
| Deferred fixed | Future date | Fixed dollar amount | Pre-retirees locking in future income |
| Inflation-adjusted | Now or later | Increases with CPI | Long retirements concerned about inflation |
| Period certain | Now | Fixed, for set years | Those wanting income for a specific period |
A typical immediate fixed annuity for a 65-year-old might pay roughly $500–550 per month for every $100,000 invested. An inflation-adjusted version starts lower (~$380/month) but increases annually.
The insurer can afford lifetime payments through mortality pooling: some annuitants die early (the insurer keeps the remainder), funding payments to those who live much longer. This risk-sharing is what makes annuities uniquely able to guarantee lifetime income.
Why It Matters for Retirement Planning
Annuities address the single biggest retirement uncertainty: how long will you live?
- Longevity risk transfer: The insurance company bears the risk of you living to 100
- Income floor: Guaranteed payments cover essential expenses regardless of market conditions
- Reduced withdrawal rate: Like a pension, annuity income reduces how much you need from the portfolio
- Behavioral benefit: Guaranteed income reduces the anxiety of watching portfolio fluctuations
The trade-offs are significant: you lose access to the invested capital, payments from fixed annuities lose purchasing power to inflation, and if you die early, the insurer — not your heirs — keeps the remaining balance (unless you buy a more expensive "period certain" or "return of premium" rider).
A Practical Example
A 65-year-old retiree with $1,200,000 and $60,000/year in expenses considers using $300,000 to buy an immediate fixed annuity:
| Without Annuity | With Annuity ($300,000) | |
|---|---|---|
| Portfolio | $1,200,000 | $900,000 |
| Annuity income | $0/year | $18,000/year |
| Portfolio withdrawal needed | $60,000/year | $42,000/year |
| Effective withdrawal rate | 5.0% | 4.67% |
| 30-Year success rate | ~72% | ~85% |
Despite having $300,000 less in the portfolio, the guaranteed annuity income improves the overall success rate by 13 percentage points. The annuity acts as a bond-like income floor, allowing the remaining portfolio to be invested more aggressively in equities for growth.
Frequently Asked Questions
- What is the difference between an annuity and a pension?
- A pension is funded by your employer based on years of service and salary. An annuity is purchased directly from an insurance company using your own savings. Both provide guaranteed income, but a pension is earned through employment while an annuity is bought with a lump sum — essentially, you're creating your own pension.
- Are annuities a good investment for retirees?
- Annuities aren't investments — they're insurance products that transfer longevity risk to an insurance company. They make sense for retirees who lack pensions, fear outliving their savings, or want a guaranteed income floor. They're less suitable for those with sufficient guaranteed income, short life expectancy, or those who prioritize leaving an inheritance.
- What types of annuities are available?
- The main types are: immediate annuities (start paying right away), deferred annuities (start paying at a future date), fixed annuities (guaranteed payment amount), variable annuities (payments fluctuate with investments), and inflation-adjusted annuities (payments increase with CPI, but start lower). For retirement income, immediate fixed annuities are the simplest and most common.