What an Annuity Is and How It Works

An annuity is a contract with an insurance company that turns a lump sum of money into regular payments

You give an insurance company a sum of money — either all at once or over time — and in return, the company promises to pay you a stream of income. That income can start right away or years from now. It can last for a set number of years, or for the rest of your life. The appeal is straightforward: you trade certainty about how much money you have today for certainty about how much money you'll receive each month later.

Annuities are sold by insurance companies, not banks or brokers, though brokers can sell them on the insurance company's behalf. They are not the same as bonds, mutual funds, or savings accounts. They are contracts, and the insurance company's promise to pay you is backed by the company's reserves and regulatory oversight, not by the FDIC.

Key Takeaways

• An annuity converts a lump sum into regular monthly or annual payments, either for a fixed period or for your lifetime.
• You can buy an annuity with a single payment or contribute to it over time, and payments can begin when ready or be delayed.
• The insurance company keeps the money you don't spend and bears the risk if you live longer than expected, which is why annuities appeal to people worried about outliving their savings.
• Annuities come in several types — when ready, deferred, fixed, and variable — each with different payment structures and investment risk.
• Annuities typically charge fees and may have surrender periods during which you cannot withdraw money without penalty.

How you fund an annuity

Most annuities are funded with a single lump sum payment. You write a check to the insurance company, and the contract begins. Some people fund an annuity with money from a retirement account rollover, a pension payout, or the proceeds from selling a home or business.

A smaller category, called deferred annuities, allows you to make contributions over time — similar to how you might add money to a savings account. You pay premiums monthly or annually, and the insurance company invests that money. Payments to you don't start until you reach a date you choose, often years later.

When payments start and how long they last

An when ready annuity begins paying you within a few months of purchase. You hand over the money, and within 30 to 90 days, the first check arrives. These are common for people who have just retired and want income to start right away.

A deferred annuity delays payments until a future date you specify — perhaps age 70, or 10 years from now. The money sits with the insurance company during that waiting period, and you don't receive anything until the payout phase begins.

Once payments start, they can last for a set term — say, 10 or 20 years — or for your entire life. A life annuity pays you every month for as long as you live, no matter how long that is. If you die before the insurance company has paid out what you put in, the remaining balance typically goes to your estate or a named beneficiary, depending on the contract. If you live much longer than average, you come out ahead; the insurance company absorbs the loss.

Fixed annuities versus variable annuities

A fixed annuity pays you the same amount every month, locked in when you buy the contract. The insurance company invests your money conservatively — in bonds and stable securities — and guarantees your payment regardless of market performance. Your payment never changes, which makes budgeting predictable but means inflation erodes the purchasing power of each check over time.

A variable annuity ties your payment to the performance of investment accounts you choose — typically mutual funds. If those investments perform well, your payment increases. If they perform poorly, your payment decreases. You bear the investment risk, but you also have the potential for higher income if markets rise. Variable annuities are more complex and typically carry higher fees than fixed annuities.

Fees and surrender periods

Annuities are not free. Most charge an annual management fee, typically between 0.5% and 1% of your account balance each year, though some charge more. Variable annuities often charge additional fees for the investment management of the underlying funds. These fees are deducted from your account or from your payments.

Most annuities also include a surrender period, usually 5 to 10 years, during which you cannot withdraw money without paying a penalty. If you need to access your money during this period, the insurance company will charge you a percentage of the withdrawal — sometimes 5% to 10% or more, depending on how many years remain in the surrender period. After the surrender period ends, you can typically withdraw money without penalty, though you may still owe taxes on the gains.

Why someone might buy an annuity

The main reason people buy annuities is to eliminate the risk of running out of money. If you have $500,000 saved and you're not sure how long you'll live, an annuity converts that uncertainty into a may provide monthly check. You don't have to worry about market crashes, and you don't have to manage investments.

Annuities also appeal to people who want simplicity. Instead of tracking a portfolio, rebalancing investments, and making withdrawal decisions, you receive a predictable payment. For some retirees, that peace of mind is worth the fees and loss of flexibility.

A third reason is tax deferral. If you buy a deferred annuity inside a retirement account, the money grows tax-free until you begin taking payments. This can be useful for high-income earners who have maxed out other retirement savings options, though it's less common because most people already have tax-deferred accounts available.

What you give up with an annuity

When you buy an annuity, you lose access to your principal. The money is no longer yours to spend, invest, or leave to your heirs in full. If you die early, your beneficiaries may receive only what remains under the contract terms — which could be far less than what you paid in. Some annuities offer options to protect your heirs, but these options cost more and reduce your monthly payment.

You also lock in a payment amount that doesn't keep pace with inflation. A fixed annuity paying $2,000 per month today will still pay $2,000 in 20 years, even though that money will buy less. Some annuities offer inflation adjustments, but again, this costs more upfront and lowers your initial payment.

Annuities are also illiquid during the surrender period. If you face an emergency and need a large sum, you'll pay a steep penalty to access it. This makes annuities a poor choice for money you might need soon.

Frequently Asked Questions

Can I get my money back if I change my mind?

Most states allow a "free look" period of 10 to 30 days after you buy an annuity. During this window, you can return the contract and receive a full refund. After that period ends, you're locked in. If you withdraw money during the surrender period, you'll owe a penalty that decreases each year until the period ends.

What happens to my annuity if the insurance company fails?

Insurance companies are regulated by state insurance commissioners and must maintain reserves to back their promises. If a company fails, your state's insurance guaranty fund typically covers annuity payments up to a limit — often $250,000 per person per company. This is not FDIC insurance, but it provides a safety net.

Can I buy an annuity inside a retirement account like an IRA?

Yes, you can buy an annuity inside an IRA or 401(k). However, the tax benefits of the annuity (tax-deferred growth) overlap with the tax benefits already in those accounts, so you're not gaining much. Annuities inside retirement accounts are less common for this reason.

Is an annuity the same as a pension?

No. A pension is a benefit your employer provides and funds. An annuity is a product you buy yourself. However, when an employer closes a pension plan, it sometimes uses annuities to convert the pension into individual payments to each retiree.

What's the difference between an annuity and a reverse mortgage?

A reverse mortgage lets you borrow against your home equity and receive payments without selling the home. An annuity requires you to hand over cash upfront. Reverse mortgages are secured by your home; annuities are not. Both can provide retirement income, but they work in very different ways.