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What Is an Annuity and How Does It Work?

By EveryIncome on 2/3/23 10:00 AM

Despite Americans holding over $2 trillion in variable annuities, the average person knows little about how annuity retirement plans work or their pros and cons.

What is an annuity?

An annuity is a special type of life insurance that provides reliable income in retirement. You make premium payments toward the annuity during your working life or purchase the annuity with a lump sum before retirement.

In return, the insurance company pays disbursements for a specific period or for the life of the policyholder (and sometimes for the life of the policyholder’s spouse).

Types of Annuities

Choosing the right policy can be confusing. Here are the most common types of annuities:

Immediate Annuity

An immediate annuity provides you with a set amount of monthly payments immediately, usually for the rest of your life. An immediate annuity is usually paid for in a lump sum by rolling over all or a portion of your retirement savings.

Deferred Annuity

While immediate annuities are usually purchased upon retirement, deferred annuities are paid for by making monthly contributions to an investment plan in the years before retirement. When a prearranged date is reached, your investment is converted into an annuity, and monthly income disbursements begin.

Fixed annuity

A fixed annuity allows the policyholder to make tax-deferred contributions to the plan. The company guarantees both the principal investment and a fixed rate of interest. Income payouts are also guaranteed for a set period or for life.

Variable annuity

With a variable annuity, payments are tied to investment performance. You are guaranteed a minimum payment in retirement, with higher payments, should investments perform well.

Fixed-index annuity

A fixed-index annuity is tied to a stock market index such as the Nasdaq. Annuity contributions are tax-deferred, and payments have minimum and maximum caps. This means you receive a guaranteed range of monthly income, no matter how investments perform.


If you value secure monthly income over more risky investments, an annuity may be the right retirement plan for you. Depending on the type of annuity you choose, advantages include:

  • No annual contribution limits
  • Tax-deferred payments
  • Guaranteed payments for specific periods or life
  • Ideal for retirees who fear they’ll run out of retirement funds before the end of life
  • The chance to benefit from profitable markets without risking capital


Depending on the type of annuity you choose, disadvantages include:

  • High fees and commission rates
  • Complex, difficult-to-understand contracts
  • Investment options that are limited to the insurance company’s portfolio
  • High surrender penalties should you want to break the deal
  • Lack of ability to take full advantage of profitable markets
  • Cannot inherit funds unless the annuity comes with a death benefit

Pros and Cons of Variable Annuities

In addition to the above-mentioned advantages and disadvantages, variable annuities are exempt from probate issues. In some states, annuity policies are protected from creditors.

Heirs can inherit any remaining amount in your variable annuity account, but beneficiaries pay tax on the entire contract value of the policy.

Variable annuities also have some of the highest fees among annuity plans and come with high penalties for early withdrawal of funds.

Pros and Cons of Fixed-index Annuities

The pros and cons of fixed-index annuities are less complicated than those of variable annuities, but still need careful consideration of the following:

  • Premiums are flexible.
  • Interest rates are higher than those in comparable banking products.
  • Most fixed-income plans allow for early retirement without penalties.
  • Payments are guaranteed.
  • Money isn’t lost in a down market (but there are earning caps on market performance).
  • Most fixed-income annuities do not provide inflation protection.
  • Surrender charges are high.

The Bottom Line

The stable monthly payments from annuities are great, but they may not keep pace with inflation. Consider combining an annuity with other retirement planning options.

This article is provided by EveryIncome.

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