When an Annuity Might Fit Your Retirement Plan

What an annuity does and why someone might buy one

An annuity converts a lump sum of money into a stream of payments that arrive on a schedule you choose — monthly, quarterly, or annually — for a set period or for life. The reason someone buys one is to trade the risk of managing a large sum for the certainty of a predictable paycheck. If you have saved a substantial amount and want to stop making investment decisions, or if you are worried about running out of money in your 80s or 90s, an annuity removes both problems by shifting that risk to an insurance company.

The trade-off is that once you hand over the money, you cannot get it back in a lump sum, and if you die before the insurance company has paid out what you gave them, the remaining balance typically goes to the company — unless you buy a version that pays your beneficiary. This is why annuities are not right for everyone, and why the decision hinges on your specific situation: how much money you have, how long you expect to live, whether you need access to the principal, and how much certainty matters to you compared to growth potential.

Key Takeaways

• An annuity provides a fixed monthly or annual payment for life or a set number of years, which removes the need to manage investments or worry about depleting savings.
• You trade liquidity and growth potential for predictability; once you buy an annuity, you cannot reverse the decision or access the principal as a lump sum.
• Annuities are most useful if you have already saved enough to cover basic expenses and want to convert part of that savings into may provide income.
• The cost of an annuity — the price you pay relative to the payments you receive — depends on your age, the payout period, and whether you add features like survivor benefits.
• An annuity does not replace other retirement accounts; it is one tool among several, and most people use it alongside Social Security, pensions, or investment accounts.

How an annuity payment is calculated

The insurance company uses three main factors to decide how much you receive each month: the amount you give them, your age when you buy the annuity, and how long they expect to pay you. A 65-year-old who buys a $300,000 annuity will receive a different monthly amount than a 75-year-old who buys the same annuity, because the 75-year-old has fewer years left to live and the company will pay out the money faster.

If you choose a single life annuity, payments stop when you die. If you choose a joint and survivor annuity, payments continue to your spouse or beneficiary after your death, but your monthly payment is lower because the company expects to pay for two lifespans instead of one. If you add a period certain option — guaranteeing payments for 10 or 20 years regardless of whether you are alive — your payment drops further, because the company is taking on more risk.

The actual dollar amount varies by insurance company and by current interest rates. Companies use mortality tables and interest rate assumptions to set prices, so shopping around matters. A $300,000 annuity might pay $1,500 per month at one company and $1,600 at another.

When an annuity makes sense in a retirement plan

An annuity is most useful if you have already saved enough money that you can afford to lock some of it away. If you have $500,000 saved and Social Security will cover your basic living expenses, you might buy a $200,000 annuity to cover healthcare costs and inflation, and keep the remaining $300,000 in investments or a savings account for flexibility and emergencies.

An annuity also makes sense if you are uncomfortable managing investments or if you have a long family history of living into your 90s. The longer you live, the better the annuity looks in hindsight, because you receive more total payments than you would have earned in interest on the original sum. Conversely, if you have serious health problems or a short life expectancy, an annuity is usually a poor trade.

Some people buy an annuity because they have reached an age where they want to stop thinking about market risk. A 75-year-old with $1 million might not want to spend the next 20 years worrying about stock market downturns, even if staying invested would produce more money. The psychological value of knowing exactly what will arrive in your account each month can outweigh the mathematical value of higher returns.

What you give up when you buy an annuity

The most significant loss is liquidity. Once you buy an annuity, the money is gone. You cannot withdraw $50,000 for a medical emergency or a grandchild's education. Some annuities offer a small withdrawal allowance — typically 10 percent of the balance per year — but this is rare and comes with a lower monthly payment.

You also give up growth potential. If you buy a $300,000 fixed annuity and the stock market rises 8 percent per year, your annuity payment stays the same. Your money is not working for you anymore; it is working for the insurance company. Over a 20-year retirement, this can mean significantly less total wealth, though it also means you are protected if the market falls.

Finally, if you die early, your heirs receive nothing unless you bought a survivor benefit. A 65-year-old who buys a $300,000 single life annuity and dies at 70 will have received only five years of payments — perhaps $90,000 total — and the remaining $210,000 stays with the insurance company. This is why many people buy annuities only with a portion of their savings, not all of it.

Annuities compared to other ways to generate retirement income

A pension is similar to an annuity in that it provides a may provide monthly payment for life, but you do not buy it — your employer funds it. If you have a pension, you may not need an annuity at all. If your pension and Social Security together cover your basic expenses, an annuity is redundant.

Social Security is also a form of may provide income, and it adjusts for inflation each year — something most annuities do not. If you delay claiming Social Security until 70, you receive a higher monthly payment for life. Many financial advisors suggest maximizing Social Security first before buying an annuity, because Social Security is inflation-adjusted and you cannot outlive it.

Keeping money in investment accounts — stocks, bonds, mutual funds — gives you liquidity and growth potential, but requires you to make ongoing decisions and exposes you to market risk. An annuity trades both of those for certainty. Neither approach is universally better; it depends on your comfort with risk, your need for access to money, and how much income you need.

Types of annuities and how they differ

A fixed annuity pays the same amount every month for the life of the contract. The payment is set when you buy it and does not change. This is the simplest type and the easiest to understand, but it means inflation erodes the purchasing power of your payment over time. A $2,000 monthly payment in 2024 might feel like $1,500 in 2034 if inflation averages 3 percent per year.

A variable annuity ties your payment to the performance of investment accounts you choose within the annuity. If your investments perform well, your payment increases; if they perform poorly, it decreases. Variable annuities are more complex, come with higher fees, and require you to make investment choices — which defeats some of the purpose of buying an annuity in the first place.

An when ready annuity begins paying you within a month or two of purchase. You give the insurance company a lump sum, and they start sending checks right away. A deferred annuity sits for years before payments begin, allowing your money to grow tax-deferred inside the contract. Deferred annuities are often sold as investment vehicles, not income vehicles, and come with higher fees and more complexity.

Questions to ask before buying an annuity

Before you commit, ask yourself: Do I have enough money that I can afford to lock some away? Will I need access to this money in the next 10 or 20 years? How long do I expect to live, and how does that compare to my family history? Do I already have a pension or substantial Social Security income? How much does certainty matter to me compared to leaving money to my heirs?

Ask the insurance company: What is the exact monthly payment, and how was it calculated? What happens if I die in year two — does my beneficiary receive anything? Can I add an inflation adjustment, and what does it cost? What are all the fees, including surrender charges if I need to exit early? How financially stable is this insurance company, and can I verify that with ratings from agencies like A.M. Best or Moody's?

Consider also whether you need to buy an annuity now or whether you could wait. Annuity payments are higher if you buy at an older age, so delaying can increase your monthly income. If you are 62 and healthy, waiting until 70 might make more financial sense than buying when ready.

Frequently Asked Questions

Is an annuity the same as a pension?

No. A pension is a benefit your employer provides and funds; you do not pay for it. An annuity is a product you buy from an insurance company with your own money. Both provide may provide monthly income for life, but only an annuity requires you to hand over a lump sum upfront.

Can I change my mind after I buy an annuity?

Most annuities have a surrender period — typically 5 to 10 years — during which you can exit the contract but will pay a penalty, often 5 to 10 percent of your balance. After the surrender period ends, you can usually exit without penalty, but you will receive the current value of the contract, not your original investment. Once payments have begun, you cannot stop them.

What if inflation erodes the value of my annuity payment?

You can buy an inflation-adjusted annuity that increases your payment each year by a set percentage or by the actual inflation rate. This costs more upfront — your starting payment will be lower — but protects your purchasing power. Alternatively, you can buy a smaller annuity and keep other money invested to offset inflation.

Do I have to buy an annuity with money from a retirement account?

No. You can buy an annuity with money from anywhere — savings, a taxable investment account, or a retirement account like an IRA or 401(k). If you use retirement account money, the payments are taxed as ordinary income. If you use after-tax money, part of each payment is a return of your principal and is not taxed.

What happens to my annuity if the insurance company fails?

Each state has a guaranty fund that protects annuity holders if an insurance company becomes insolvent. The protection limit varies by state but is typically $250,000 per person per company. Before buying, check the financial ratings of the insurance company through A.M. Best, Moody's, or Standard & Poor's to reduce the risk of this happening.