How Annuities Work and What It Takes for One to Make Sense in Your Plan

Americans put $432.4 billion into annuities in 2024, a 12% jump from the year before and the third consecutive record⁽¹⁾. That kind of money moving in one direction is worth paying attention to. It doesn't mean annuities are the right move for you, but it does mean something real is driving demand, and if you haven't fully thought through what an annuity is, how each type works, and what it actually costs, now is a useful time to do that.

A plain fixed annuity and a variable annuity loaded with riders are about as similar as a savings account and a leveraged ETF. They have completely different risk and cost profiles. Most of the distrust people have about annuities comes from conflating these two ends of the spectrum.

This breakdown covers what an annuity is, why guaranteed income matters in retirement, the four main types and how they compare, how to read the real costs, and how to evaluate whether any of it belongs in your plan.

What an annuity actually is (and what it isn't)

An annuity is a contract between you and an insurance company. You hand over a lump sum (or a series of payments) and in return, the insurer guarantees you income. That income can start immediately or years from now, depending on the structure you choose.

The core purpose is straightforward, as annuities exist to solve the longevity risk problem. You can manage a lot of financial variables including your spending rate, your asset mix, and your Social Security timing, but the one thing you can't manage is how long you'll live. An annuity transfers that uncertainty to an insurer. They take on the risk that you'll live to 95 or beyond, and you get predictable income regardless.

Neither is better across the board, they're just tools for different jobs. The goal in retirement income planning is usually to figure out how much of your income needs to be guaranteed (and therefore belongs in something like an annuity) and how much can tolerate some variability (and therefore belongs in a portfolio)⁽¹³⁾.

There are two broad timing structures:

1. An immediate annuity starts paying within a year of purchase, useful if you're at or near retirement and want income now.
2. A deferred annuity has an accumulation phase first, your money grows tax-deferred before you start drawing income, typically 5-15 years later.

As a concrete anchor for reference, a $200,000 immediate annuity for a 65-year-old currently pays approximately $1,112/month on a joint-life payout or $1,234/month on a single-life payout⁽⁶⁾⁽⁸⁾.

Why annuity sales hit record levels, and why that matters to you

Three years of consecutive sales records isn't a coincidence. Two things are driving it, and both are worth understanding before you decide what to do with this information.

First, interest rates.

Fixed annuity payouts are directly tied to rates. When rates are higher, the income an insurer can guarantee goes up. After years of historically low rates, the rate environment of the past few years made fixed and fixed indexed annuities more attractive than they'd been in a long time. For someone who'd been watching from the sideline, 2024 was the first time fixed annuity payouts looked competitive against other conservative income options.

Second, demographics.

Roughly 73 million Americans will be 65 or older by 2030⁽⁴⁾. That's a lot of people moving from the accumulation phase (building wealth) to the distribution phase (spending it) at the same time. The distribution phase creates a very specific anxiety, because while Social Security and any pension might cover the basics, they often don't cover healthcare surprises, a longer-than-expected retirement, or the lifestyle gap between what you're guaranteed and what you're used to spending. Annuities address that gap.

Record sales doesn't mean that annuities are right for everyone. It reflects a genuine market need. They don't tell you whether a particular product fits your income picture, your liquidity needs, or your risk tolerance. Knowing the different types of annuities helps you understand when they may be right for you.

The four main types of annuities (and how they differ)

This is where most people's understanding breaks down, because the word "annuity" gets applied to four very different products. The type you choose determines the cost, the risk you carry, and whether the product fits your situation.

[Greensprout internal link: See our guide to retirement income strategies]

Fixed annuity

You deposit a lump sum, and the insurer guarantees a fixed interest rate for a set term, typically three to ten years. At the end of that term, you can take income, renew, or move the money. It functions somewhat like a CD, with the added option to convert to a guaranteed income stream.

• Who it's for: People who want certainty above all else. The return is predictable, the fees are low, and the structure is simple enough to explain to anyone in your family.
• The tradeoff: That predictability comes at a cost to growth. In an inflationary environment, a fixed rate that looked solid in year one might look thin by year ten. Fixed annuities don't adjust for inflation unless you add a specific rider at additional cost.

Variable annuity

Your premium goes into sub-accounts (essentially mutual fund-like investment options) and your account value rises and falls with market performance. If the sub-accounts perform well, your income can be higher than a fixed annuity. If they underperform, your payout reflects that (unless you've added a living benefit rider, covered below).

• Who it's for: People with a higher risk tolerance who want growth potential inside an income-guaranteed structure. The insurer wraps market exposure in a contract that still promises some floor of income if you add the right riders.
• The tradeoff: Variable annuities carry the heaviest fee load of any annuity type. A variable annuity with a 1.25% mortality and expense fee, 0.90% in fund expenses, and a 1% income rider totals 3.15% per year in annual costs⁽⁵⁾. That's before any surrender charges. On a $100,000 contract, that's $3,150 annually working against your balance. For that cost to make sense, the underlying investments need to consistently outperform what you'd earn net of fees in a lower-cost alternative.

Fixed indexed annuity (FIA)

Your money doesn't go directly into the market; it stays with the insurer. The interest credited to your account is tied to the performance of a market index, usually the S&P 500. If the index goes up, you capture a portion of that gain, up to a cap. If it goes down, your principal is protected and you earn zero interest that period.

• Who it's for: People who want some growth potential without the direct downside exposure of a variable annuity. The principal protection removes the worst-case scenario, and the index-linked interest gives you more upside than a plain fixed annuity in good market years.
• The tradeoff: The cap limits your upside. In a year when the S&P 500 is up 20%, you might credit 7-10% depending on your contract's cap and participation rate. FIA sales hit $125.5 billion in 2024, up 31% year-over-year⁽¹⁾, which suggests a lot of people find this middle-ground structure appealing. Just understand what you're trading for protection.

Registered index-linked annuity (RILA)

A RILA is essentially an FIA with a twist: instead of full principal protection, you accept a defined buffer of downside risk in exchange for a higher cap on gains. For example, a 10% buffer means the insurer absorbs the first 10% of index losses, and you absorb anything beyond that. In exchange, your upside cap is typically higher than an FIA would offer.

• Who it's for: People who can tolerate limited downside, say, a loss of more than 10% in a severe market, in exchange for more growth potential. RILA was the fastest-growing annuity product in recent years, reaching $62 billion in sales in 2024 and $37 billion in H1 2025 alone, up 20% year-over-year⁽³⁾.
• The tradeoff: You are taking on real market risk, even with the buffer. In a severe downturn, the kind that drops markets 30-40%, a 10% buffer can still lead to substantial losses. Know your buffer depth before signing.

Here's how the four types compare across the dimensions that matter most:

Immediate vs. deferred annuities: the timing decision

Beyond the product type, there's a second decision that shapes how an annuity fits your plan, which is when do you want income to start?

An immediate annuity (technically called a Single Premium Immediate Annuity, or SPIA) is funded with a single lump sum, and income payments begin within 12 months. You're essentially converting a chunk of savings into a pension-like income stream right now. SPIAs generated $13.6 billion in sales in 2024⁽¹⁾. They're simple, low-cost, and well-suited for someone already retired or within a year or two of stopping work who wants to lock in a guaranteed income floor without waiting.

A deferred annuity has two phases. During the accumulation phase, your money grows tax-deferred inside the contract, whether at a fixed rate, tied to an index, or invested in sub-accounts. You then trigger the income phase later, typically 5-15 years down the road. Deferred annuities work well for someone 50-60 who wants to start building a guaranteed income stream they'll tap at 65 or 70, letting the accumulation phase work in the meantime.

The tax treatment applies to both types and is worth understanding clearly before you commit. Inside the annuity, growth is tax-deferred, you don't pay taxes on gains while they accumulate.

For annuities held inside a traditional IRA or 401(k), called "qualified" annuities, the entire withdrawal is taxable income. For annuities purchased with after-tax dollars outside a retirement account, called non-qualified annuities, the IRS applies a 'Last-In, First-Out' rule. This means the earnings portion is withdrawn and taxed first, before you can access your tax-free principal. Both types are subject to a 10% IRS penalty on withdrawals taken before age 59½^(11)(12). This isn't a reason to avoid annuities, but it is a reason to account for the tax impact in your income plan before buying.

What annuities cost, in real dollar terms

This is where a lot of annuity conversations go wrong. Fee percentages get mentioned, but they rarely get translated into what they mean on your actual contract. Here's a clear-eyed breakdown of what you're looking at.

Surrender charges

Most annuities come with a surrender period, typically 6 to 8 years, during which you'll pay a penalty if you withdraw more than a defined amount. A common schedule starts at 7% in year one and declines by one percentage point per year until it reaches zero by year eight⁽⁹⁾.

Most contracts allow withdrawals of up to 10% of the account value per year without triggering a surrender charge, so you're not completely locked in. But if you need to access a large portion of the funds during the surrender period, the charge is real money. On a $200,000 contract in year one, a 7% surrender charge is $14,000.

Mortality and expense (M&E) fees

These are annual fees the insurer charges to cover the cost of the income guarantee and the death benefit. On variable annuities, M&E fees typically run 0.5% to 1.5% per year⁽⁵⁾.

On a $100,000 contract at 1.25%, that's $1,250 annually, deducted directly from your account value. Fixed and indexed annuities usually don't charge M&E fees as a separate line item; the cost is built into the rate or cap structure instead.

Administrative fees

Typically around 0.3% of account value or a small flat annual charge, covering record-keeping and contract administration. Minor on its own, but it adds to the total.

Fund expenses (variable annuities)

Variable annuity sub-accounts carry their own internal expense ratios, similar to mutual fund fees. These average around 0.50% to 1.00% per year, on top of the M&E fee.

Rider fees

Optional features added to the contract, covered in the next section, come with their own fees. A living benefit rider typically adds 0.5% to 1% per year to your total cost⁽¹⁴⁾.

Stack the numbers and a variable annuity can reach 3.15% or more annually in total fees: 1.25% M&E, 0.90% fund expenses, and 1% income rider⁽⁵⁾. That's $3,150 per year on a $100,000 contract, every year.

Here is how those fees stack up in real dollar terms:

• Mortality & Expense (M&E): 1.25% ($1,250)
• Sub-account Fund Expenses: 0.90% ($900)
• Guaranteed Income Rider: 1.00% ($1,000)
• Total Annual Cost: 3.15% ($3,150)

Commissions

You don't write a separate check for the agent's commission, it's built into the contract's pricing and it's real money. Commissions on annuities range from 1% to 8% of the premium, depending on the product⁽⁷⁾. On a $200,000 annuity, that's $2,000 to $16,000 going to the selling agent at purchase⁽⁷⁾. Higher-commission products aren't automatically bad, but the incentive structure is worth knowing.

Riders: what they add and what they cost

Riders are optional add-ons to an annuity contract that customize what the product does. They're worth understanding because they're where a lot of the value, and a lot of the cost actually lives.

Living benefit riders

These guarantee a minimum income or withdrawal amount regardless of how your account value performs. The most common type is the Guaranteed Lifetime Withdrawal Benefit (GLWB), which lets you withdraw a set percentage of a guaranteed base amount each year for life, even if your actual account value has declined to zero. Note that this guaranteed withdrawal percentage applies to a separate 'benefit base' used solely to calculate income, not the cash amount you can withdraw as a lump sum. Other variations include the GMAB (Guaranteed Minimum Accumulation Benefit), GMIB (Guaranteed Minimum Income Benefit), and GMWB (Guaranteed Minimum Withdrawal Benefit), each with slightly different structures and trigger conditions⁽¹⁴⁾.

These riders matter most for variable annuity buyers who want market exposure but also want a guaranteed income floor. For fixed or indexed annuities, which already have structural guarantees built in, the value of adding a separate living benefit rider is lower and the cost may not be worth it.

Death benefit riders

A death benefit rider ensures that if you pass away before fully collecting what you put in, your beneficiaries receive at least the original premium, a stepped-up value, or some defined minimum amount. Some annuity contracts include a basic version of this at no extra charge; enhanced death benefits with a higher guaranteed amount carry additional fees⁽¹⁴⁾.

Inflation protection riders

These adjust your income payments upward over time to offset inflation. They're less common, add to the annual cost, and are worth evaluating carefully, because the adjustment rate in the rider may or may not keep pace with actual inflation.

The practical rule on riders is they're worth the cost when they address a specific concern you actually have, longevity, health uncertainty, leaving something to heirs. They're less worth the cost when added as general protection because they sound reassuring. Evaluate each rider against its annual price tag and ask yourself, ‘what specific situation is this covering, and is that situation likely enough and costly enough to justify the fee?’

Three common annuity mistakes

These aren't beginner errors. They show up regularly among financially experienced people who understand investing but are newer to this specific product category.

Mistake 1: Treating all annuities as one product

A variable annuity with 3%+ in annual fees is a fundamentally different instrument than a straightforward SPIA or fixed annuity with no M&E fees and a defined payout schedule.

Conflating these is why people either over-buy, thinking the guarantees justify any cost, or reflexively avoid the entire category based on stories that apply to the most complex products, not the simplest ones. Before forming an opinion on annuities, figure out which type you're actually evaluating.

Mistake 2: Locking in too long a term or too large an amount

This one is more common than most advisors acknowledge. Buyers put more money into an annuity than necessary, tying up liquidity they'll later regret losing. The more useful framework is to identify your income floor, which is the gap between your guaranteed Social Security income, plus any pension, and your actual baseline monthly expenses. That gap is the number an annuity needs to cover. Cover it with as little as needed. Invest the rest.

Longer surrender periods typically come with higher agent commissions. Short-term annuities, 3-year or 5-year products, exist and are often overlooked by buyers who don't know to ask for them. A shorter surrender period preserves flexibility and still delivers the guaranteed income you're after.

Mistake 3: Ignoring the tax treatment

Many buyers assume annuity income will be taxed like capital gains in retirement. It won't be. Withdrawals from an annuity are taxed as ordinary income, regardless of how long you've held the contract⁽¹⁰⁾.

For buyers who hold a large non-qualified annuity alongside Social Security income and other taxable sources, a significant annuity withdrawal can push a portion of income into a higher bracket. This doesn't make annuities the wrong choice, it makes the tax planning part of the evaluation, not an afterthought.

When an annuity fits, and when it doesn't

There's no universal answer here, and any resource that tells you otherwise isn't being straight with you. However, there is a framework for evaluating whether a guaranteed income product belongs in your specific plan.

An annuity tends to fit when you have a real income gap. For example, the difference between what Social Security and any pension covers and what you actually spend monthly, and you want to close that gap with something guaranteed rather than relying on portfolio withdrawals. It also fits when longevity is a concern, when you don't need full liquidity on this portion of savings, and when the certainty of a defined income floor is worth more to you than the flexibility of keeping everything invested.

It tends to fit less well when a pension already covers most of your monthly baseline, when you have a shorter life expectancy, when your priority is leaving assets to heirs rather than maximizing income, or when the liquidity you'd be giving up during the surrender period creates real risk for your cash flow.

If your Social Security income plus any pension covers at least 80% of your baseline monthly expenses, an annuity may add less marginal value than simply investing that capital in a diversified, income-oriented portfolio. If there's a gap, say your guaranteed income covers $2,800/month and you need $4,200, then annuitizing $150,000 to $200,000 to fill that $1,400 monthly gap is a legitimate use of the product. For a 67-year-old with $1 million in savings, annuitizing can yield approximately $53,154 in first-year income versus $40,000 under the 4% rule, a 33% income advantage⁽¹⁵⁾.

The partial annuity approach is also worth considering. Use a SPIA or fixed annuity to lock in a guaranteed income floor, invest the remainder of your portfolio for growth, flexibility, and liquidity. You get the longevity protection where it matters most without surrendering more capital than necessary to the insurer.

Key takeaways

• Annuities are a category, not a product. Fixed, variable, indexed, and RILA annuities have fundamentally different cost structures, risk profiles, and use cases. Evaluate the specific type, not the label.
• The core value of an annuity is longevity protection. Converting a lump sum into guaranteed income you can't outlive, transferring the risk of a long retirement to an insurer.
• Fixed and SPIA annuities carry the lowest fees and the simplest structures. Variable annuities carry the most layers, M&E fees, fund expenses, rider costs, and total annual costs can reach 3%+.
• Before buying, ask for the all-in annual cost as a dollar amount on your contract value. Also ask about the surrender schedule and how much you can withdraw penalty-free each year.
• Most people don't need to annuitize everything. The goal is usually to fill an income gap, not replace a portfolio. Use the minimum necessary to secure the income floor, then invest the rest.

Compare retirement income options

If you're working through whether an annuity belongs in your plan, the most useful next step is to talk to an advisor and see how the numbers work against your actual income needs.

Disclaimer

Annuity products and their terms vary by issuer, state, and contract. Information presented here does not constitute investment advice or a recommendation for any specific product. Greensprout's editorial team writes on behalf of the reader. Our goal is to provide clear, useful information to help you make better financial decisions. Our editorial content is not influenced by advertiser relationships. Greensprout is an independent, advertising-supported publisher and comparison resource. We may earn compensation when you click on links to products from our partners. This does not affect our editorial standards or recommendations. Nothing on this site constitutes investment advice. All investors are encouraged to conduct their own research before making any investment decision. Past performance is not a guarantee of future results.

Sources