What Is an Annuity?

The Simple Definition

An annuity is a contract with an insurance company where you give them a lump sum of money, and in return, they promise to pay you regular income—usually monthly—for a specific period or for the rest of your life.

Think of it as creating your own personal pension. Instead of relying on an employer pension (which most people don't have anymore), you're essentially buying a guaranteed income stream.

How It Works

Purchase Phase

You transfer money to an insurance company. This could be from an IRA, 401(k), or regular savings. You can invest a lump sum all at once or make payments over time.

Accumulation Phase (Optional)

With some annuities, your money grows tax-deferred before you start taking income. This phase can last years or decades.

Income Phase

When you're ready, you "annuitize" the contract, which means you start receiving regular payments. These can last for a set number of years or for your entire lifetime.

Types of Annuities

Fixed Annuities

Pay a guaranteed interest rate and fixed income payments. Most conservative option. Predictable returns, but typically lower growth potential.

Variable Annuities

Returns vary based on performance of underlying investments (like mutual funds). Higher growth potential but also market risk.

Indexed Annuities

Returns tied to a market index (like S&P 500) but with downside protection. You participate in some market gains while avoiding losses.

Immediate Annuities

You give the insurance company money and start receiving payments right away (typically within a year). No accumulation phase.

Real-World Example

Meet Sarah: Sarah is 65 and has $300,000 in her IRA. She's worried about market volatility and wants guaranteed income to cover her basic expenses.

She decides to use $150,000 to purchase an immediate fixed annuity. Based on her age and the contract terms, the insurance company guarantees her $750 per month for the rest of her life.

She keeps the other $150,000 invested in her IRA for growth and emergency funds. This way, she has both guaranteed income and growth potential.

Key Benefits

•Guaranteed Income: You know exactly what you will receive and when
•Longevity Protection: You can't outlive your income
•Tax Deferral: Many annuities grow tax-deferred
•No Market Watching: You don't need to manage investments

Important Considerations

Limited Liquidity: Once you annuitize, you typically can't access the lump sum
Fees: Some annuities have high fees that eat into returns
Inflation Risk: Fixed payments lose buying power over time
Insurance Company Risk: Payments depend on the insurer's financial strength

Is an Annuity Right for You?

Annuities aren't right for everyone. They work best for people who:

•Want guaranteed income to cover basic living expenses
•Are worried about outliving their savings
•Don't want to manage investments in retirement
•Have other assets for emergencies and legacy goals