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Annuity Basics 101: How Annuities Work

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Annuity Basics 101: How Annuities WorkAnnuities are a tool to hedge against a very real and serious risk:  that of running out of money during retirement.  There are many valid reasons to be worried about running out of money:

  • Traditional pensions are becoming rare.
  • Nobody knows what will happen to Social Security.
  • Healthcare costs are skyrocketing, and employer provided healthcare benefits during retirement are becoming scarce.
  • Many people can’t afford to save as much for retirement as they should.
  • People are living longer now than ever before due to advances in medical science, so retirement assets must last longer.  Many people will likely spend 25 – 30 years in retirement.
  • Sticking to an appropriate withdrawal rate during retirement can be difficult for many people.

An annuity may be one mechanism to help your assets last, no matter how long you live.


Annuities are basically insurance contracts that allow you to convert a lump sum of money into a lifelong stream of income, which can be an effective hedge against longevity.  Payments generally continue until you die.

Annuity as an Investment

Annuities generally don’t make great “investments.”  Unless you live a long time or the stock market has a huge meltdown during your retirement, there is a good chance you would have been better off financially investing your money elsewhere.

However, nobody knows how long they will live or what the future holds with any certainty.  Although very unlikely, the stock market could tank right when you enter retirement and then stay flat for 15 years after that.  An annuity could be a great investment to have if that were to occur.

Personally, I consider an annuity to be more of an insurance product than an investment.

Annuity as an Insurance Product

I think it is fair to say that most insurance products don’t end up being great “investments.”  Take disability insurance for example.  The odds of me ever getting much benefit out of my long term disability insurance policy are fairly low.  I would most likely receive a better return investing my premiums elsewhere.

Does that mean I shouldn’t have a long term disability insurance policy?  Of course not.  When purchasing insurance, I don’t ask what happens if I never get disabled, my house never burns down, or I never get in a serious car crash.  Instead, I ask what would happen if those things did occur, even if the odds of them occurring is quite low.

Over my lifetime, I will probably pay tens of thousands of dollars in insurance premiums for various types of insurance.  You probably will too.  If my home never burns down or I never become disabled, then I may not get a dime of it back and I would have been better off having never purchased the insurance.  Does that mean I shouldn’t have purchased them in the first place?  Of course not, since there is no way of knowing beforehand and the risk is always there.

Insurance should generally be used to protect against risks that although unlikely, could cause financial devastation.  I personally consider longevity to be one of those risks.  Outliving assets during retirement could very well turn into a financial catastrophe in my book.

Living to age 95 may be rare, but how many people would still be able to maintain their accustomed style of living if they lived to age 95?  Most people would have run out of money years earlier.

If I end up living a long time then I’ll probably get my money’s worth and then some out of an annuity, just like if I ever become permanently disabled I’ll likely receive back much more than I put in to my disability insurance policies.

Regardless of when I die, having an annuity will bring peace of mind since I’ll know that no matter what happens, I won’t outlive my money.

Pros and Cons of Annuities.

There are some great benefits to having an annuity; however, there’s also a lot not to like.


  • Helps prevent people from outliving their assets
  • Helps diversify your retirement income
  • May be a good investment if you live a long time or the stock market performs extremely poorly.
  • Brings peace of mind
  • In return for a lower payout, you can purchase an annuity that adjusts payouts for inflation and/or that leaves a portion of your investment to your heirs.


  • Terms may be complex and confusing.
  • High fees and commissions.
  • You can generally receive a better return on your money elsewhere.
  • Upon your death, generally none of the money you invested in the annuity will pass to your heirs, unless you accept a lower payout.
  • Inflation may erode the value of your income stream, unless you accept a lower payout.
  • Annuities are very illiquid.

Factors to consider

There are many factors you should consider when trying to determine if an annuity is right for you.  Here are a few of them:

  • Risk tolerance
  • Importance of having guaranteed income for life
  • Retirement age
  • Desired retirement standard of living
  • Desired level of financial security
  • Assets, wealth, and income sources
  • Family longevity
  • Bequest goals
  • Health

Who Annuities May Not Be Appropriate For

Annuities are not appropriate for everyone.  For example, they may not be appropriate for the following people:

  • The wealthy
  • People in very poor health
  • People who want to leave an inheritance to their children or others (although they could still leave other assets or accept a lower annuity payout in exchange for part of their investment passing to their beneficiaries)

Who Annuities May Be Most Appropriate For

An annuity may be appropriate for you if:

  • Your nest egg may not last you through retirement and that is a worrying thought to you
  • You are worried you may have difficulty sticking to an appropriate withdrawal rate during retirement
  • Peace of mind is very important to you; you want the assurance that you won’t run out of money.

Should I annuitize everything?

You probably shouldn’t drop all of your assets into an annuity because of the disadvantages to owning an annuity.  However, annuities have enough upside that they find a place in many people’s retirement portfolios.

The proper amount, if any, to put into an annuity will vary by person.  I’m guessing that when I retire I’ll invest somewhere in the ballpark of 5% – 20% of my retirement assets in an annuity–enough to hopefully cover my basic monthly living expenses in retirement that Social Security and any pensions won’t cover but no more than that.

State Guaranty Associations

Each state has a private state guaranty association that will make good on an annuity if the insurance company becomes insolvent.  However, there are limits.  I believe the minimum limit for any state is $100,000 and many states have higher limits.

However, there are ways to easily raise this number substantially by purchasing multiple annuities through various companies.  Purchasing various annuities over time could also increase your overall payouts as well, if they are purchased during a time when interest rates are increasing.

Shop Around

Annuity rates will vary by company, so obtain quotes from a number of different companies.  Shopping around can help you find the best deal possible on your annuity, potentially earning yourself thousands of dollars more than you otherwise would.

Additional Information

For additional information on annuities, you might take a look at the following books:

What are your thoughts on annuities?  Do you plan on purchasing an annuity some day?  If you already own one, are you glad you purchased it or do you regret the decision?  Leave a comment below!

Image: MaryPerry/bigstock


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