How to Select and Shop for an Annuity

  • Tips

    • Annuities are especially great for people nearing retirement age and by professionals who use them for asset-protection purposes.
    • Any withdrawals made before age 59 ½ are subject to taxes and a 10% penalty.
    • Annuities are great from a tax perspective: your investment grows tax-deferred.

An annuity is a retirement account with air bags. Buyers invest a sum of money in a particular annuity, and in exchange, they’re guaranteed a steady monthly check for a set number of years, or for life. The money in an annuity is invested by an insurance company and you, in turn, receive a series of payments.

Annuities are issued by insurance companies and sold by insurers, brokerages and mutual fund companies. All are marketed as investments that provide peace of mind for people who want to secure their lifestyle in retirement and ensure they won’t outlive their savings.

Annuities tend to be purchased by people under age 40, people nearing retirement age and professionals who want to protect their assets. But high expenses and fees can erode an annuity’s performance and value, so it’s essential to shop carefully and compare these products with other investments. For instance, for some retirement savers, a Roth IRA might be more suitable than an annuity.

The amount you will receive monthly from an annuity depends on the type of annuity you select, how much you invest, how your investment performs prior to retirement, and which features you add on—such as electing to transfer your payments to your spouse in the event of your death.

Annuity payments are subject to income taxes. Withdrawals made before age 59½ are subject to taxes and a 10% early-withdrawal penalty.

There are two main kinds of annuities:

Immediate annuity —You invest a lump sum, and the insurance company begins sending you regular monthly payments right away. You decide in advance whether you prefer receiving a fixed amount for the life of the annuity or a fluctuating amount (“variable”) based on the performance of the investments in your annuity. There are some inflation-related risks to this option.

Deferred annuity —You invest one or more sums with the insurance company years before your retirement date. During these years, your investments have a chance to grow, tax-deferred.

When you reach retirement age (at least 59½), the amount of your monthly checks will depend on the total size of your annuity portfolio.

There are three different types of deferred annuities—each with trade-offs and risks:

Fixed deferred annuity —Your lump sum investments are placed in a low-risk asset portfolio and earn a guaranteed annual rate of return until retirement.

Variable-deferred annuity —You invest in stock and bond funds offered by the insurance company that holds your annuity. At retirement, your account can be worth more or less than your initial investment.

Equity-indexed annuity —Your investment mirrors the performance of a broad stock index, such as the S&P 500. The insurance company protects against market declines by guaranteeing a minimum return on your investment.

Annuities sure sound like a great retirement-savings deal: Unlike a 401(k), IRA or SEP (Simplified Employee Pension), you can contribute as much as you wish; your investment grows on a tax-deferred basis; and you can rest easy knowing you’ll receive monthly payments for the duration of your contract.


Consider an immediate annuity if:

• You are near retirement age;
• You haven’t saved enough in your retirement plans to provide sufficient income;
• You need steady retirement income in addition to social security payments and your other investments;
• You worry about outliving your savings;
• You have no family to support you if your savings run out;
• You want your spouse to receive a steady income if you precede him or her in death.

Consider a deferred annuity if:

• You are under age 40. Investments in these securities historically require 15 to 20 years to achieve a rate of return that exceeds other low-risk investments.
• You are a likely target for litigation by former clients, creditors or a divorcing spouse. Doctors, lawyers and now even financial and real estate professionals are at risk. In most states, annuities are protected from third-party claims against your assets.
• You want to swap out of a lousy annuity or poorly performing universal life insurance policy. Through what’s known as a “1035 exchange,” the IRS allows you to transfer the cash value of one insurance product to another without triggering tax penalties. The money can still grow tax-deferred, and the losses you suffered in the insurance policy can be used to offset the annuity’s gains for tax purposes upon withdrawal.

Before you invest in any type of annuity, consider the drawbacks:

• Fees charged by insurance companies on annuities can be relatively high, which eats into your returns over time.
• Calculations used by insurance companies to determine rates of returns on some investments are complex and can suppress long-term earnings.
• Returns on an annuity investment over time might have been higher if assets had been invested in non-annuity mutual funds.
• Cashing in an annuity to withdraw your invested assets can be costly, because you may have to pay surrender charges to the insurer.
• Some annuities’ rules force your beneficiaries to forfeit part or all of your investment if you die.
• Sales pitches may sound good, but they still must be carefully evaluated. For example, many insurance companies encourage you to roll your IRA into an annuity. But annual annuity fees can be as much as 3%, which is much higher than other long-term investment vehicles like mutual funds in an IRA or 401(k), and your rate of return could be lower than expected.
• Inflation can undercut the value of a fixed monthly payment for life, especially after income taxes are paid.

If an annuity makes sense for your needs, here’s what you need to consider when narrowing your choice:

Calculate the payout. How much monthly income are you likely to receive based on the sum you plan to invest?

Check the strength. Buy annuities only from financially strong insurance companies. Check their ratings at A.M. Best or Fitch Ratings.

Verify returns. Look carefully at how an annuity’s investment returns are calculated. The returns on funds offered by insurance companies tend to be lower than equivalent open-end mutual funds due to higher fees and expenses.

Add up the expenses. Find out exactly what you’ll be charged in expenses, commissions and fees. Stick with variable annuities that charge no more than 2%.

Explore the death benefit. What will your spouse receive if you die before deferred-annuity payments are due to begin? Consider an extra fee to boost the annuity’s death benefit.

Size up surrender fees. What will you be charged if you choose to cancel the annuity and withdraw your savings? Some annuities charge a penalty of 6% or 7% in the first seven years. In addition, your gains will be taxed as income, and you’ll face a 10% penalty if you’re under age 59 ½ at the time of withdrawal.

Consider low-fee annuities. Variable annuities offered by major mutual fund companies like Vanguard, Fidelity and T. Rowe Price tend to charge lower fees—around 2%.

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