What Role Should Annuities Play In Retirement?

Today:  A controversial subject:  Annuities.  Regardless of strong opinions on all sides, I’ll make an effort to address the question of “What Role Should Annuities Play In Retirement?” (or at least provide a general overview of the topic).

For those of you who are new readers (btw, lots of you lately, much appreciated!), you’ll learn that I often weave in “harder” financial/investment articles along with the “softer” articles about retirement planning (Purpose, anyone?).

Make no mistake.  today’s is a “harder” article, about a specific retirement planning investment tool.  If you hate the “Hard Finance Stuff”, feel free to pass (I promise I won’t be offended).  Have Faith, more “softer” stuff is on the way in the very near future (Hint Hint:  Watch out for a “Weekend Edition” in the next few days).

BTW, I sometimes struggle with the right balance between the two styles…but I digress.

What Role Should Annuities Play In Retirement?

I’ve had this article in “Draft” for months.  It’s an important topic, and one worthy of discussion here on The Retirement Manifesto.  However, it’s also a very controversial subject, with valid reason.  I’ve struggled with how to address the topic, and finally decided it’s time to finish this post, build up the courage to hit “Publish”, and provide my first “Annuity” post for you, my reader.  It will live forever in my archives, along with other “investment specific” articles I’ve written in the past.  I hope I give the topic a fair report.

My Disclaimer

First:  I am not, and do not pretend to be, a financial professional.  I’m simply a 54 year old guy who’s working toward early retirement, who’s enjoyed personal finance as a semi-serious hobby for 32 years, and has learned some stuff along the way.  I’m merely offering you readers a “no cost journey” down my path as I work through The Retirement Red Zone.

Today, Annuities. From a guy who's merely offering a No Cost Journey on his road to FIRE. Click To Tweet

To be clear, I am FAR from an expert on annuities.  I’ve studied them a bit, considered buying some a year ago (even talked to Vanguard’s Annuity experts), did some analysis, and decided to wait.  I think I’ll buy something (likely a deferred longevity annuity, but I get ahead of myself) in the next ~10 years or so.

I haven’t decided yet whether I’m going to buy an annuity.

That’s Me.  My situation.  My decision.

I don’t know anything about your situation, and do not pretend to be making any recommendations.  I’m attempting to provide an objective description of the various annuity types, explain what situations they may be useful for, and some risks to consider with the product.  This is not intended to be a comprehensive summary, and there are important details which you will need to study for your situation.

Use this as a diving board into the world of annuities, but realize you still can't swim. Click To Tweet

DO NOT get into annuities without FULLY understanding what you’re committing to.

I wouldn’t want you to drown.

The Controversy.

Annuities are a hot topic for controversy.  I won’t attempt to fully explain the arguments that either side has, but a general summary is in order.

The “Annuities Are Bad” view:  Let’s start with the “Annuities Are Bad” camp. In my humble opinion (with apologies in advance to anyone I may offend), the controversy stems around potential Conflict Of Interest in the financial advice industry.  Due to complicated pricing structure, commissions, and high fees involved in many annuities, some cite the risk that a “financial expert” may be enticed into selling you a “high fee” (and, high commission) product that isn’t necessarily in your best interest.  Learn enough about this stuff yourself to have an intelligent conversation with an adviser.  Then trust, but verify.

The “Bad” view also makes the argument that you can generate a higher lifetime income stream, at a lower expense, by using an appropriate Withdrawal Strategy, and investing your money into a diversified portfolio instead of into an annuity.

The “Annuities Are Good” view:  On the other hand, there’s no doubt that there is some merit to the various annuity products, and there are places where they are exactly the right tool for the job.  As mentioned, I’m considering them as a potential addition into our retirement cash flow plan (see deferred longevity annuity below), and have done some general studying on annuities. There’s no doubt that they work extremely well in meeting the retiree’s cash flow needs in specific situations.  They also may provide useful as a tax optimization strategy, as well as reducing/deferring your Required Minimum Distribution after age 70 1/2 (outside the scope of this article).

Annuities – The Basics

The Primary Concept

Annuities, as a gross generalization, are an insurance product.  You’re essentially paying for the assurance that you’ll have a future cash flow.  The annuity is a product in which the investor provides a lump sum of money to a counter-party (often, an Insurance Company).  In return, the Insurance Company provides a steady and potentially lifelong flow of cash back to you for your retirement spending.  Guaranteed income for a number of years, or for the remainder of life, depending on the annuity structure.

Dana Anspach, a financial writer I respect, (and author of Control Your Retirement Destiny, the best book on retirement planning I’ve read) uses the analogy of cookies and a cookie jar to explain annuities.  In essence, you give the insurance company your cookie jar, and they hand you back a cookie each year.  It’s a good analogy.

Hey Dana, one thing I’d propose adding to your analogy, if I may be so bold, is this:

  • “The rationing of cookies by the cookie jar holder also insures you don’t eat too many cookies at once, to control your diet.” (hereby declared, by me, as “The Retirement Manifesto Addendum”).  I hope you like it.  Smiles.

While the primary concept is fairly easy to understand, annuities can get complicated when you start looking at the varieties and structures of different annuity products.  The general principle is the same (but please check into the details of any annuity you’re considering):

The Investor puts in up-front money, and receives a future flow of retirement cash.

The Risks Of Annuities

There are some “snakes in the grass” in the world of annuities, and it’s important that you understand the risks before you commit any retirement funds to the purchase of an annuity. Below are some general risks associated with the annuity concept.  Rather than address risks associated with each specific type of annuity, I’ll be providing a more generalized summary of risks.  (Notice I said “risks” 4 times in the above paragraph, it was intentional.  Pay attention, class!).

  • Early Death = Lose Your Money:  If you were to die shortly after placing your lump sum, your heirs could lose access to the money.  In the case where the annuity income stream ends at deaththe payback on your initial sum is higher if you live a long time.  Die young, you lose.  There are options to eliminate this risk (your heirs can get your lump sum back when you die), but they come at added fees, see the next bullet:
  • High Fees:  Various annuity structures have high fees, with variable annuities averaging 2.35% in fees. The more complex the structure, the higher the fees (add in that living benefit rider from bullet #1, and your fee jumps to 3.4%!!).  Avoid complexity, and buy the simplest hammer you need to drive your nail.  The fees are a major drawback on variable annuities, in particular.
  • Loss of Liquidity:  Once the lump sum has been used for the purchase of the annuity, it is no longer accessible for you to spend in the event of an emergency (you gave up the cookie jar, remember? And, based on “The Retirement Manifesto Addendum” you’re only getting 1 at a time to control your diet, remember?). Make sure you only invest $ into an annuity that you won’t need for short-mid term living expenses.  Early withdrawal penalties can be steep.
  • Counter Party Risk:  Since the future flow of income is guaranteed by the financial institution which sold the annuity, there is some risk should that institution become insolvent.  Stick with only the highest rated companies, your future income depends on them staying afloat.
  • Inflation:  If you annuity generates a fixed income stream, it will lose purchasing power over time to inflation.  While there are inflation riders available, they result in a significantly lower payout than a fixed annuity in the early years (another “fee”, in effect).  There’s no free lunch.

Interest Rate Impact

In addition to the risks mentioned above, There are various things that affect the economics of annuities.  Beyond fees, the interest environment has a tremendous impact on the cost/benefit of buying an annuity.  In a low interest rate environment, the investor gets less cash flow in return for the same investment than she would receive if she were to invest the same amount in a high interest rate environment.

Annuity 101: The Higher The Interest Rate, The More Attractive The Return. Click To Tweet

An investor needs to be aware of the interest rate environment, and the impact of increasing/decreasing rates on annuity returns, when deciding on making an investment into annuities.   (For the record, I suspect that interest rates are starting a slow, bumpy upward grind for decades to come. Then again,  I really don’t know anything).

In my case, I’ve decided to delay my purchase of an annuity, primarily due to:  1) my need for short term liquidity (did I tell you I’m retiring early?), and 2) my view on interest rate trends. I’ve decided to wait until I’m 60 to revisit the potential purchase of an annuity, but continue to monitor the annuity market in the interim. One purchasing strategy is to buy annuities over a period of years, to minimize “interest rate risk”, but that’s beyond the scope of this overview.

Annuity Types

Fixed Annuity

A Fixed Annuity provides a fixed rate of return to the investor from the financial institution. There is no stock market risk, and the interest rate and payout rate is fixed for a period of time (~5-10 years) and known at the time of the annuity purchase.  These are a “safe, low risk” investment, but that comes along with lower rates of return. Think of them a bit like a Certificate Of Deposit. These are typically the least complicated, and lower cost, of the annuity choices.

Indexed Annuities are a variant of a fixed annuity, but the interest rate is tied to a specific index (e.g., S&P 500). These are sometimes referred to as Fixed Index Annuities, or FIA’s.  (I don’t know about you, but I find all of the nomenclature surrounding annuities to be a bit confusing.  If you’re thinking of investing, take the time to learn the language of annuities). 

Variable Annuity

A Variable Annuity offers investors the potential of earning a higher rate of return than a fixed annuity, while also assuming some return risk.  Unlike fixed annuities, a variable annuity does typically have stock market exposure, and various other investment classes may be customized within the portfolio.

Income payouts fluctuate based on actual returns.  In addition, investments into the annuity can be made over a number of years instead of a single “lump sum” payment. With a death benefit rider, a variable annuity can provide a payout to the owner’s beneficiaries of no less than the original lump sum investment.  Further riders can be purchased which guarantee a minimum return.  As you can see, the variable annuity can get complex (and expensive), and should only be pursued after all of the implications (and costs) are clearly understood.  For the record, I’m not a big fan of variable annuities.

Immediate Vs. Deferred Payouts

For both Fixed and Variable annuities, the investor has the choice between an immediate or deferred payout period.

  • Immediate:  Sometimes called a Single Premium Annuity, or Income Annuity, in which payments back to the investor begin shortly after the lump sum is deposited (typically within 30 days).  Payments can last for a fixed number of years (a “term-certain” annuity), or guaranteed to pay until death.
  • Deferred:  Sometimes called a “Longevity Annuity”, these are typically used to build up a future payout on a tax-deferred basis.  Payouts are delayed in a deferred annuity for a period of time (~10 years) after the initial investment, allowing payout values to increase (the longer the deferral, the larger the growth of the payout). These annuities can be useful in protecting against longevity risk, given that a relatively small upfront investment can grow into a helpful lifelong income stream starting later in life.

In our retirement planning, I’m considering a deferred annuity as a hedge against longevity risk.  We’ll likely get serious around Age 60, with a 15-20 year deferral (allowing payments to start at Age 75-80, and set it up to last as long as we live).

Annuities As A Retirement Tool

To determine whether an annuity is the right tool for your retirement planning, you first have to understand what cash flow objective you’re attempting to solve.  Then, you need to consider the risks. Some situational examples are below:

  • No Pension:  In the event where you have a base spending level of “required spending” with no guaranteed income, the use of an annuity can provide some comfort in knowing you’ve got a guaranteed income stream for life.  Establishing an annuity income stream to cover your essential living expenses is a valid situation for potential use of an annuity.  This could also be used as a “top off” between your expected Social Security income and the minimum income level required to cover your basic needs.
  • Longevity Risk:  If you’re worried about outliving your money, a deferred annuity may make sense for you as “longevity insurance”.  This is the area I’m considering for our retirement strategy.  In our case, we’ll consider buying a deferred fixed annuity sometime during our 60’s, with a start date in our late 70’s.  Payments (retirement income) would continue until death, providing us some insurance against a very long life.
  • Income Diversification:  Just like there’s value in having a diversified asset allocation, there’s value in having diversified income streams in retirement.  If you’re overly dependent on one source of income (e.g., your stock portfolio), diversifying into annuities may be a reasonable step to reduce your overall risk.
  • Tax Strategy:  If you’re in need of additional tools to make tax deferred investments, annuities do allow a means of investing in a variety of fund types with tax deferred dollars.  They are also a tool to help reduce/defer your Required Minimum Distribution (RMD) after Age 70.  I wouldn’t suggest you “go solo” on this one, best to hire a financial adviser, or talk to Vanguard, to discuss the specifics of your situation.

According to this survey from Retirement Journeys, 11% of Baby Boomers plan on using annuities as a component of their retirement income plan.  As I said, they are a valuable tool in the right situation, and you should familiarize yourself with the product and decide for yourself if there’s a place for them in your retirement portfolio.

Additional Resources

I’ve taught myself the basics about annuities, but I’m no expert. Following are some of the articles “from the experts” which I found particularly useful as I researched this post:


Anyone working on their retirement financial plan should be aware of annuities.  They are a “tool in the toolbox”, and you should be aware of the potential benefits that annuities can provide.  As more people are impacted by the “extinction” of the defined pension plan, I suspect annuities will get more attention in coming years.  In my view, it’s only a matter of time before 401(k) plans start offering annuities as a way of converting your nest egg into an income stream for life. Take the time to understand annuities, and talk to an expert if you think there may be a fit with your situation.

Just beware the risks, and understand all of the fees, before you give away your cookie jar.


PS:  To assist you in finding my “investment specific” articles, I’m considering a “compilation post” in the future. Perhaps, a “Table Of Contents” type of post, with links to the various investment-specific articles I written over the past two years.  Let me know in the Comments if you’d be interested (and I just may pull it together for you!).


  1. Great detail in this article. Thanks for that!

    Coming from 403b world (think TIAA-CREF), annuities are big business. And I see so many colleagues end up in this product with both good and bad outcomes. You provided a great resource guide for others to follow so I’ll be sure to share.

    My take – the fees, inflation risk, loss of liquidity make them a poor tool to consider in today’s market climate. That said, I agree wholeheartedly that things can/will change . . . healthcare costs and the longevity risk will have me keep the annuity option top of mind as we reach our 60s/70s. Again, great post!

      1. Nice compendium, though some discussion of the concept of “mortality credits” would be useful. Annuities can payout slightly more than regular bond investments due to the premium return passed on by the half of annuitants that pass away before their life expectancy, benefiting the other half.

        If bonds are a cornerstone of the retiree’s portfolio, replacing some of them with a SPIA helps improve returns, lower risk and aid psychologically. Dangerous to imbed much of an interest rate prediction into the decision, but if must, then stagger over time the purchase of SPIAs to potentially capture the changing yields. Assume stocks or TIPs will provide some inflation protection to offset the fixed payouts of the SPIA (or DIA).

        Informative articles like this can help counter the “annuity anomaly”, of people rejecting annuities, and improve the uptake of such a helpful product/tool. Nice job.

        1. Ah, an expert weighs in!! Glad to get a “Nice job” shoutout from someone who REALLY knows this stuff! I appreciate your addition to the discussion, good point about using annuities as a potential replacement for some of a retirees bond allocation. (and, regarding “mortality credits”, you assume I know more than I actually do….smiles).

  2. Great information, Fritz! In the no pension category, another thing to consider is dementia. For someone living alone in declining mental health, guaranteed monthly mailbox money could be a big help.

    Personally I’m not a huge fan of annuities but the important thing is to understand the product and the risks before making a commitment. I think you’re on the right path in considering a payout starting around age 75. You might want to compare the differences between buying a deferred annuity to pay out at age 75 vs. buying an immediate annuity at age 75.

    1. GREAT add on the dementia angle, and a perfect example of why I love “Comments” on blogs! I missed that one, and it’s potentially a biggie.

      Good point about Deferred vs. Immediate at Age 75, will include that in my review at Age 60. Thanks for the great comment, and for contributing to the discussion!

  3. Fritz, thanks so much for this helpful article on annuities.
    My husband and I are 61 and 62. We visited with the Fidelity financial planner assigned to our accounts last month. My question to him was: should we consider an immediate “bridge” annuity in order to delay taking Social Security until we are both 70?
    And he said; “I don’t think a bridge annuity would be useful in your situation because your Required Minimum Distributions at 70 1/2 will be a significant issue for you. (Our retirement accounts are all tax deferred).
    I wish I knew what action to take with that information, but I’ve cooled off on bothering with an annuity for now.

    1. Cyn, thanks for making my point about annuities being complicated. I would suspect he was arguing that your RMD will be problematic, so you may consider taking some early withdrawals from your IRA instead of an annuity. Assuming I’m interpreting his comment correctly, there is a potential tax angle in his taking IRA withdrawals early, up to your next tax hurdle rate. Beyond the scope of a comment, but you may want to also call Vanguard (see the link in my article) to get a second opinion.

  4. Welcome to the flock of black sheep cautiously admitting that annuities might be ok! I was expecting more backlash when I published my annuity pieces a little while ago, but it seems that people are warming back up to them.

    I really like that cookie jar analogy. And all in all a good piece. One note on the counter-party risk. While absolutely true that you don’t want to deal with a company that goes under, I think in most states the annuity contacts themselves are backed by a government insurance similar to FDIC, so you wouldn’t lose your money.

    1. Daniel, us black sheep need to hang together, the wolves can only eat one of us at a time….

      Good point about the gov’t insurance on counter-party risk, and a nice add to the discussion – definitely something I missed in the article! Thanks for stopping by!

    2. Daniel had commented to me about an annuity in a recent post too (and wasn’t shot down by too many!) People definitely seem to have an opinion on this. In terms of my own learning, this was huge Fritz. Thanks!

  5. Dirk Cotton over at the Retirement Cafe is starting in on annuities too.

    A few months ago (Feb 2017) he wrote a great blog post on retirement decisions with expiration dates. I thought that one a great lead-in to talking about annuities, as if/when/how-much annuities might help out will change as one ages.

  6. Great post! I do think the risk of default is higher than most think. For example in the 2008-9 crisis one of the world’s largest and highest rated insurance companies, AIG, would have gone bankrupt and likely would have defaulted on their annuity portfolio had the feds not bailed them out. I don’t think the current administration would cave in to the “too big to fail” sentiment that saved AIG. The advice to pick a financially strong company would have steered many to AIG.

    I also think hyper inflation could destroy most annuities value while diversified portfolios can generally keep up with any inflation rate. However the one you are considering has some appeal as an insurance policy. I’m 61 and I’ve seen double digit inflation and won’t be surprised to see it again. I also retired at 60 financially independent and applaud your quest to retire early. I love it, it is literally the best time on my life so far. And I loved my job, but retirement is even better.

  7. Fritz, great post! This is a very touchy subject with strong opinions on both sides, so I welcome the impartial expose here. Whole life insurance, reverse mortgages, annuities, etc. all have the disadvantage of low transparency and high fees. Not a huge fan. But I like the idea of a small deferred annuity to insure against the extreme tail event of living into my 90s. Who knows, with medical advances that may not be such a tail event anymore by the timeI get there?! As long as it’s only a small amount and not the bulk of retirement savings, that seems like a savvy move!

  8. I’m one of the lucky few that will retire with a pension (Federal Employee), but if i wasn’t i would probably consider an Annuity for a portion of my retirement income. Regardless of all the bad, the goodness of a steady stream of income might provide a peace of mind that outweighs more than the bad.
    Having said that, as rates rise, and the trend seems to point higher in the coming years it seems you could also create a safe way to get a steady flow of interest income with having more control.

  9. Great job on presenting the information in an unbiased way. I’m not a fan of annuities but it doesn’t hurt to keep my knowledge up to date in case I change my mind.

  10. I go back and forth on annuities and yes they may play a partial role in retirement. When I was exploring the other I saw many options including an annuity that included return of initial investment at death, so they return the cookie jar.

    My biggest concern is inflation. I have to look to see in any of the annuities have an inflation escalation payment. When I did some math it seemed like I could do better, however that is based on historical return which we may not receive going forward.

  11. Fritz, thank you for taking this post on and hitting that publish button! Very helpful post and some great comments too. My mom was talked into an Annuity in her mid 50’s with high fees and all. At the time I was not convinced it was the right thing but she had already pulled the trigger. I need to revisit the details for her now so she can determine when to start drawing on it, so this post was the perfect reminder, thanks.

  12. Good post, Fritz – glad you dug it out of the drafts! 🙂

    I’ve considered getting a fixed annuity but for a whole different reason. We’re discussing the possibility of moving and retiring early to Panama. If you have something like a pension or other guaranteed income for life, they will grant you a Pensionado Visa which can give you some awesome discounts on everything you do there (restaurants, medical, travel, etc).

    For our family of three, we would need to have $1,250/mo. of guaranteed income to qualify. I haven’t dug into it enough, but I thought an annuity might be a way to make that happen if that doesn’t run too much and would make sense in the long run.

    — Jim

  13. Thx for the hard article. It is a good summary of the situation and risks.

    I am on the same boat as you: consider setting one up in our 60s.

    Keep us posted!

  14. This is a really good introductory article, and nicely balanced!

    I have a few comments as someone who is in the business of analyzing and recommending these for clients. (disclaimer: I make money when people buy them).

    As ColoradoCFA mentioned, a discussion of mortality credits and how they work would be good — these are basically the reason that these products become better deals the older you get. For most people, at some age (generally >50), the expected insurance value of the mortality credits (your longevity insurance) becomes greater than the cost for some piece of their portfolio. The outliers are people who have way more assets than they need ( FIA > VA, but the chance of beating the guarantee is the opposite. There’s a lot of variation by individual contract too. Some contracts I would *never* sell to anyone in every one of the categories.

    There’s a lot to these, but for those approaching traditional retirement ages, it’s very common for them to make a plan more stable due to the longevity insurance aspect. I very rarely recommend them to someone younger than age 45. Only for someone who needs the income now and ongoing *and* is super conservative would they make sense. The tax advantages are fairly limited relative to a low turnover strategy in a taxable account.

    1. The Gnome is active today! (Thanks for your comment here, and on the PAW post!). Glad to see “the experts” weighing in on this topic. I’ll be the first to admit that “mortality credits” and the cost/benefit analysis of them is well beyond my scope of expertise on this topic! Great to get your input!

      1. Something bugged out in my comment. I had a whole thing written about VAs vs. FIAs. I’m not sure if I deleted it accidentally in editing or if the site ate it because my comment was too long. 🙂

        The piece you see as FIA > VA… was supposed to be something like this:

        The highest guaranteed income is normally SPIA > FIA > VA, but your chance of beating the guarantee is the opposite, as usually is the long term expectation.

        One note about VAs: they look like they have higher fees, but in general the costs of all three types are fairly similar if they have similar levels of guarantee and expectation. All of them pay lucrative commissions. VAs have “fees” because they are considered a securities product and regulated by FINRA/SEC. FIAs and SPIAs are considered insurance products regulated (generally much more loosely where transparency of costs are concerned) by the states. I have watched non-registered (no securities license) agents describe their fixed products as having no fee versus the high fees of VAs. I’d be in big trouble for getting caught saying something like that. FIAs have spreads, caps and participation rates, all of which end up basically determining how much of your investment goes to you vs. the insurance company — effectively a cost, just not *called* a “fee”.

        IME, the Insurer profit and agent compensation on fixed indexed annuities is comparable to VAs, and plain fixed annuities and SPIA are pretty close as well. Also, you can’t save the agent comp by dealing direct with an insurer, they just take that for themselves and make you deal with someone random over the phone. So if you find an agent/advisor who is actually helping you make a good decision and not trying to ram you into something without paying attention to your best interest, go ahead and get it from them.

        That’s all stuff that got deleted somehow on the last post which I thought was relevant.

  15. Thanks for the comprehensive review on anuties. They have their shortcomings, but can serve a role for some people. As you said, they can be valuable for those who do not have a pension and are afraid of running out of money. Another alternative to buying an annuity is to postpone drawing Social Security until age 70.

  16. Thanks for this post Fritz. It’s really a shame what’s happened to the annuity market as a result of these newer market-linked products, like variable and indexed annuities. I’m an actuary and spent years at New York Life working with insurance and annuities. The pure income annuity is extremely valuable protection against longevity and market risk. Without pensions, we don’t have many other options. But, because the products evolved (to be easier for agents and brokers to sell) to become investments with the potential to become annuities, not actual annuities, it’s gotten way too confusing for everyone. Income annuities are not the only answer to someone’s retirement – because of inflation and the lack of liquidity – but I think they should be the foundation of most people’s. I’m worried about our overall society’s prospects for retirement given that everyone’s money is in the market and we’re not pooling any risk. I’m starting a blog myself — calling it The Pensioneer — about my and my company’s efforts to create a new pension system using annuities. I’ll let you know when it launches :). Thanks again!

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