Back > Annuities  > Understanding Annuities: A Comprehensive Guide for Retirement Planning

Understanding Annuities: A Comprehensive Guide for Retirement Planning

As you approach retirement, ensuring a stable and secure income stream becomes a top priority.

“When most workers think about expenses in retirement, the first thing that comes to mind is pensions,” says Martin Walcoe, President & CEO at David Lerner Associates, Inc. “However, annuities have gained prominence as an effective tool for retirement planning over the last few decades.”

This article will delve into the world of annuities and provide a comprehensive understanding of their features, benefits, and considerations for those contemplating retirement.

What are Annuities?

Annuities are long-term contracts issued by financial institutions (primarily insurance companies) designed to provide a regular income stream during retirement.

In essence, the same insurance company that covers your home may also help you save for retirement.

The value of the annuity derives from you funding the annuity contract through periodic payments or a lump sum. Then, at a certain point in time, the annuity pays you (or your beneficiaries) an amount over a definite period of time or for the rest of your life.

Types of Annuities

Different types of annuities exist to address the diverse needs of the market. There are generally five types of annuities:

  1. Fixed Annuities – These pay you a fixed amount based on an interest rate provided in the contract. State insurance commissioners regulate fixed annuities. To confirm whether an insurance broker is registered to sell insurance in your state, please check with your state insurance commission.
  2. Variable Annuities – These require you to engage in market risk by directing your money to different investment options, typically mutual funds, and potentially grow your retirement savings. Your pay-out will depend on how much you put in, your investments’ rate of return, and expenses. Variable annuities are regulated by the SEC.
  3. Indexed Annuities – These allow you to be credited by the insurer for the return of a stock index, like the S&P 500 Composite Stock Price Index. State insurance commissioners are in charge of regulating indexed annuities.
  4. Immediate Annuities – These are typically purchased with a single lump‐sum premium, and payouts begin within one year of purchase.
  5. Deferred Annuities – These are typically purchased with periodic payments, and the payout begins at some future date, allowing time for tax‐deferred growth.

Basic Elements of an Annuity Contract

A typical annuity will generally include the following provisions:

  1. The parties – Insurer/issuer of the contract, the owner of the contract, the annuitant (typically same as owner), and a beneficiary (if the annuitant dies).
  2. A surrender period.
  3. Premium payment arrangements.
  4. An amount or rate of return per period once payments begin.
  5. Other terms to address the policy.

How Much Do Annuities Cost?

Annuity contracts entail various fees that can vary depending on the specific policy.

While the following list highlights some common fees associated with annuities, it is important to review your own policy to gain a complete understanding of the applicable fees and how they are used by the company.

  1. Mortality and Expense Risk Charge: Also known as M&E fees, these charges cover expenses related to policy sales, such as commissions, as well as the provision of death benefits that are typically included in the policy.
  2. Administrative Fees: Most companies impose an annual fee to cover administrative costs associated with managing the contract. Sometimes, this fee may be waived if the contract value exceeds a specified threshold.
  3. Surrender Charges: Insurance companies often limit the amount that can be withdrawn during the initial years of the contract, applying surrender charges on withdrawals that exceed a predetermined limit (e.g., 10 percent per contract year). Understanding the surrender charge schedule for your specific policy is key, as these charges can be substantial and enforced over an extended period.
  4. Investment Management Fees: If you opt for a variable annuity, the subaccounts within the policy where your funds are invested function similarly to mutual funds. Like mutual funds, these subaccounts often incur management fees for investment services. Consult the annuity prospectus for details on underlying funds to determine the potential investment management fees.
  5. Rider Charges: When applying for an annuity, you may have the option to select additional enhanced guaranteed benefits beyond the standard policy provisions. These benefits, offered through riders, typically come at an additional cost. It is essential to fully comprehend the riders you’re purchasing, ensuring that any added benefits align with your expected needs and justify the associated expenses.
  6. Penalties: If you withdraw money from an annuity early (before you hit 59.5 years), you may have to pay the IRS a 10 percent tax penalty on top of any taxes you owe on the income.

By thoroughly reviewing your annuity policy and understanding the fees involved, you can make informed decisions that align with your retirement goals.

Benefits of Annuities

  • Unlimited contributions: Regardless of your income or how you earn it, you can contribute as much money as you wish into an annuity after taxes.
  • Lifetime Income Guarantee: Annuities offer a predictable income stream for life, helping retirees manage longevity risk and ensure financial security.
  • Tax Advantages: Annuities come with potential tax advantages, including tax-deferred growth and the option for tax-free transfers or conversions.
  • Protection Against Market Volatility: Certain types of annuities shield investors from market fluctuations, providing stability and peace of mind during retirement.
  • Death Benefits for Heirs: If you die before you start receiving payments, your beneficiary will receive a specific payment.

Drawbacks of Annuities

While annuities can offer several benefits, it’s important to understand their drawbacks before making an investment decision.

Some potential drawbacks of annuities include:

  1. Limited liquidity: Annuities are typically designed as long-term investments, and early withdrawals may result in surrender charges and tax penalties. This lack of liquidity can restrict access to your funds when needed.
  2. Fees and expenses: Annuities often come with various fees, including administrative fees, mortality and expense fees, investment management fees, and surrender charges. These costs can reduce the overall return on investment (ROI).
  3. Complex Product Structures: Annuities can have complex features and contractual terms, making them challenging to understand fully. It is critical to carefully review the T&Cs of the annuity contract to ensure it aligns with your financial goals.
  4. Limited investment options: Fixed annuities may offer limited investment options compared to other investment vehicles. Variable annuities provide more investment choices but come with market risk, as the returns are tied to the underlying investments’ performance.
  5. Potential for Inflation Risk: Fixed annuities may not protect against inflation. As the purchasing power of money decreases over time, the fixed income from an annuity may not maintain pace with inflation, resulting in a reduced standard of living in the future.
  6. Loss of Control: Once funds are invested in an annuity, you typically surrender control over those funds. This lack of control can restrict your ability to react to changing financial circumstances or take advantage of new investment opportunities.
  7. Tax Implications: While annuities offer tax-deferred growth, withdrawals are generally subject to income taxes. If you withdraw your funds before you reach the age of 59.5, you may also face an additional 10 percent early withdrawal penalty.

It is crucial to carefully evaluate your financial situation, investment goals, and risk tolerance before considering an annuity. Consulting with a retirement planning expert can help determine if an annuity aligns with your overall retirement and investment strategy.

Annuities vs. 401(k)

Of course, annuities aren’t the only choice that offers tax‐deferred growth potential; retirement plans such as 401(k) do that as well.

So how do annuities stack up against 401(k)? First, as mentioned, annuities are financial products sold by or through an insurance company. 401(k), on the other hand, is a savings plan for employees offered by their employers.

A 401(k) can be funded with various investments, including stocks, bonds, mutual funds, and annuities. But you can also own an annuity separate from your 401(k).

In any case, annuities and 401(k) share some common features and some different characteristics as well.

Feature Annuities
Tax‐deferred earnings
Tax‐deductible or pretax contributions
Unlimited contributions
Guaranteed minimum death benefit
Tax on withdrawals
Guaranteed lifetime income

Avoiding Fraud

Follow these tips to keep yourself safe:

  • When searching for an annuity, ensure you buy from an independent licensed agent or broker.
  • If you are buying an annuity for a tax-deferred retirement program, such as an IRA, ensure you’re eligible.
  • Don’t buy the first contract you are offered. Compare contract summaries and policy benefits from different companies.
  • You should never feel pressured into purchasing an annuity- if you do, walk away.
  • Be wary of insurance agents who tell you to replace your current annuity with a new one. Before you decide to cancel your annuity, ensure you understand the surrender charge and any tax consequences.


Understanding annuities is crucial for older investors and individuals preparing for retirement. By comprehending the various types, benefits, and considerations associated with annuities, you can make well-informed decisions to secure a stable income stream during your golden years.

Remember that careful evaluation, professional guidance, and ongoing monitoring are essential to maximizing the potential advantages annuities offer in building a solid retirement plan.

David Lerner Associates is here to support your journey toward a secure retirement. Contact our team of experienced advisors to explore how annuities can play a vital role in your financial well-being.

Material contained in this article is provided for information purposes only and is not intended to be used in connection with the evaluation of any investments offered by David Lerner Associates, Inc. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable– we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

Your Investment Counselor

Skip to content