Annuities Explained: Types, Costs, and When They Make Sense

A $4 Trillion Market Built on One Promise

Americans held approximately $4 trillion in annuity assets as of 2023, according to the Insurance Information Institute—a figure that has grown steadily as baby boomers seek guaranteed income to supplement Social Security. An annuity is a contract between an individual and an insurance company in which the individual makes a lump-sum payment or series of payments, and the insurer provides regular disbursements beginning either immediately or at a future date. The mechanism is straightforward. The mathematics, fees, and embedded options are anything but.

The Two Phases of Every Annuity

All annuity contracts pass through two distinct phases. The accumulation phase is the period during which money grows inside the contract, either through declared interest rates, market participation, or separate account investments. The distribution phase begins when the contract owner elects to begin receiving payments—either through annuitization (converting the contract to a guaranteed income stream) or systematic withdrawal provisions. The transition between phases is irreversible under traditional annuitization: once annuitized, the policyholder surrenders the lump sum in exchange for the income stream. Modern annuities with living benefit riders have partially addressed this rigidity.

Three Core Annuity Types Compared

Feature	Fixed Annuity	Fixed Indexed Annuity (FIA)	Variable Annuity (VA)
Interest crediting	Declared rate (guaranteed)	Index-linked with cap/floor	Subaccount (market) returns
Principal protection	Full (insurer guarantee)	Full (0% floor)	None without rider
Upside potential	Low (2%–5% typical 2024)	Moderate (capped at 8%–12%)	High (no cap, market returns)
Typical annual fees	None (spread-based)	None base (rider: 0.5%–1.5%)	2%–4% (M&E + fund + riders)
Regulated by	State insurance dept.	State insurance dept.	SEC + state insurance
Surrender period	3–10 years	5–10 years	5–8 years (B-share)

Fixed Annuities: Guaranteed Rates and Spread Economics

Fixed annuities credit a declared interest rate to the account value. The rate is set by the insurer and can be renewed annually or locked for a multi-year guaranteed annuity (MYGA) period—typically 3 to 7 years. MYGAs function similarly to certificates of deposit: the rate is contractually fixed for the entire guarantee period. In 2024, top MYGA rates reached 5.0%–5.5% for 3-year terms as insurers passed through rising bond yield environments. The insurer's profit comes from the spread between what it earns on its investment portfolio and what it credits to the policyholder—typically 100 to 200 basis points.

Mortality and Expense Fees in Variable Annuities

Variable annuities carry explicit annual fees that compound against performance. The mortality and expense (M&E) fee compensates the insurer for the mortality risk it assumes and covers administrative expenses. The fee ranges from 0.5% to 1.5% per year of account value. Added to underlying fund expense ratios (0.5%–1.0%) and any optional rider charges (0.5%–1.5% each), total annual costs in a variable annuity with income guarantees commonly reach 3%–4% of account value per year. The drag is significant: a 3.5% annual fee on a $200,000 account equals $7,000 per year withdrawn from compound growth.

Surrender Charge Schedules

Annuities impose surrender charges—penalties for withdrawing funds before the end of the surrender period. Surrender charge schedules are expressed as a declining percentage applied to withdrawals exceeding the free withdrawal provision (typically 10% of account value per year).

Contract Year	B-Share VA Surrender Charge	Typical FIA Surrender Charge
Year 1	7%	10%
Year 2	6%	9%
Year 3	5%	8%
Year 4	4%	7%
Year 5	3%	6%
Year 6	2%	5%
Year 7	1%	4%
Year 8+	0%	0% (after year 10)

Annuitization Options

When a policyholder elects to annuitize, the insurer converts the accumulated value into a guaranteed income stream. The payout options determine how long benefits continue and whether a survivor benefit exists:

Life only: Highest monthly payout; payments cease at death regardless of how long the contract has paid. Advantageous only if the annuitant lives significantly beyond life expectancy.
Joint and survivor: Continues payments to the surviving spouse—at 50%, 75%, or 100% of the original payment—after the primary annuitant dies. Lower initial payment than life only.
Period certain: Guarantees payments for a fixed number of years (10, 15, or 20). If the annuitant dies within the period, payments continue to the beneficiary.
Life with period certain: Combines a life income with a guaranteed minimum period, providing both longevity protection and a legacy floor.

Annuitization is permanent. The numbers rarely reverse.

1035 Exchange Rules

Section 1035 of the Internal Revenue Code allows policyholders to exchange one annuity contract for another—or a life insurance policy for an annuity—without triggering immediate taxation on accumulated gains. The exchange must be a direct transfer between insurance companies, not a liquidation followed by a purchase. Key rules:

The annuitant (not just the owner) must remain the same in both contracts
The exchange must be non-taxable at exchange date; gain defers to the new contract
Exchanging into a new contract typically restarts the surrender charge schedule
Cost basis transfers to the new contract for tax calculation purposes at distribution

A 1035 exchange is commonly used when a policyholder seeks better rates, lower fees, or enhanced living benefit options without incurring immediate capital gains tax on decades of deferred growth.

Suitability Concerns and Regulatory Standards

Annuities are frequently sold to investors for whom they are unsuitable—particularly elderly individuals in the distribution phase who cannot afford long surrender periods, or investors who have already achieved tax-deferred growth through qualified retirement plans (IRAs, 401(k)s), making the annuity's tax-deferral feature redundant. The SEC's Regulation Best Interest (Reg BI), effective June 2020, requires broker-dealers to act in the customer's best interest when recommending annuities. The NAIC updated its Suitability in Annuity Transactions Model Regulation to align with Reg BI standards, including training requirements for agents recommending indexed and variable products.

Secure 2.0 and Qualified Longevity Annuity Contracts

The SECURE 2.0 Act of 2022 expanded the use of qualified longevity annuity contracts (QLACs) within IRAs and defined contribution plans. QLACs allow retirees to defer annuity payments to as late as age 85, reducing required minimum distributions (RMDs) in the interim. Under 2024 rules, individuals may invest up to $200,000 (indexed to inflation) of their IRA balance in a QLAC. The amount sheltered in the QLAC is excluded from the RMD calculation until payments begin, providing a tax-planning lever for retirees concerned about RMD-driven tax bracket creep in their 70s and 80s.

Disclaimer: This article is for informational purposes only and does not constitute financial or tax advice. Consult a licensed financial professional before purchasing any annuity product.