What Are Annuities: Fixed, Variable, Indexed, and Whether They Make Sense

What Is an Annuity?

An annuity is a contract between you and an insurance company in which you pay a lump sum or series of payments, and the insurance company provides you with a stream of income payments, either immediately or at some point in the future. Annuities are the only financial product capable of providing a guaranteed income stream that you cannot outlive — a feature that addresses one of the most significant risks in retirement planning: longevity risk, the risk of running out of money before you die.

Insurance companies offer annuities because they can pool longevity risk across thousands of policyholders. Some annuitants die early (before collecting much of their premium), and others live very long lives. The premiums from those who die early subsidize the payments to those who live well into old age. This mortality pooling allows annuities to provide payment streams that are more efficient than simply self-managing a portfolio to generate equivalent income.

Annuities exist on a spectrum from simple to extraordinarily complex. A straightforward immediate annuity purchased from a highly rated insurer with no additional riders is a transparent, useful product. At the other end of the spectrum, variable annuities laden with living benefit riders, multiple fee layers, and complex terms have been the subject of significant regulatory scrutiny and consumer complaints. Understanding the type of annuity being offered and its true all-in cost is essential before making any purchase decision.

Fixed Annuities

A fixed annuity credits your account with a specified guaranteed interest rate for a defined period, much like a CD but with the insurance company tax-deferral benefit. During the accumulation phase, your premium grows at the guaranteed rate. When you annuitize (convert to income payments), the insurer calculates payments based on your account value, your age, and interest rate assumptions.

Fixed annuities are among the most straightforward annuity products. They provide certainty: you know the rate you will earn, you are not exposed to market losses, and the income stream upon annuitization is predictable. The tradeoff is that fixed annuity returns are typically modest — comparable to CD or bond rates — and may lag inflation over long periods. Surrender charges, which are penalties for withdrawing more than a specified amount (typically 10% per year) during the contract's surrender period (often 5 to 10 years), limit liquidity.

Multi-year guaranteed annuities (MYGAs) are a specific type of fixed annuity that lock in a rate for a defined term — two to ten years — making them similar to term CDs in structure but with the benefit of tax deferral on interest accumulation. At the end of the term, you can renew, annuitize, or roll the funds to another product. MYGAs are among the simplest and most cost-transparent annuity products, with rates that can be compared directly against other fixed-income alternatives.

Variable Annuities

A variable annuity invests your premium in subaccounts — pools of investments similar to mutual funds — that fluctuate with market performance. The value of your annuity rises and falls with the performance of the chosen subaccounts. Variable annuities offer the potential for higher returns than fixed alternatives but also expose you to investment losses. At annuitization, payments are based on the account value, meaning they vary with market performance unless you have purchased certain guarantees.

The primary additional cost of a variable annuity is the mortality and expense risk charge (M&E charge), which typically ranges from 0.5% to 1.5% of account value per year, on top of the investment subaccount expenses. Many variable annuities also include administrative fees and optional rider fees. The total annual cost of a variable annuity — M&E charge plus subaccount expense ratios plus rider fees — often ranges from 2% to 4% per year of account value.

This cost drag is significant. A 3% annual fee on a $500,000 variable annuity represents $15,000 per year. Over 20 years, cumulative fees at that level would total $300,000 or more in absolute terms, and far more in forgone compounding. For the annuity to be worthwhile, the benefits it provides — primarily the guaranteed income features available through living benefit riders — must exceed this substantial fee burden.

Indexed Annuities (Fixed Index Annuities)

Fixed index annuities (FIAs) sit between fixed and variable annuities. They credit interest based on the performance of a market index (most commonly the S&P 500) but with two protective features: a floor (usually 0%, meaning you cannot lose principal due to negative index performance) and a cap or participation rate that limits your upside (for example, a 10% cap means you receive up to 10% in a year when the index returns 25%, or an 80% participation rate means you receive 80% of the index return up to any applicable cap).

The appeal of indexed annuities is their asymmetric payoff: protection against market losses combined with some participation in market gains. In years when the market is flat or negative, you receive 0% or a small guaranteed minimum. In years when the market rises, you receive a portion of the gain. This downside protection is real and funded by the insurance company using options strategies — part of your premium buys options on the index, and the remainder is invested in fixed income.

The tradeoff is that the participation rate and cap mean you will significantly underperform the index in strong bull markets. Dividends are typically not included in the index calculation used for FIA crediting, which means you miss the dividend component of total return (roughly 1.5-2% annually for the S&P 500). Over long periods in strong equity markets, the cumulative cost of these limitations can be substantial. Whether the downside protection is worth this cost depends on your risk tolerance and time horizon.

Living Benefit Riders and Income Guarantees

Living benefit riders are optional features added to variable or indexed annuities for an additional annual fee (typically 0.5% to 1.5% of account value per year) that provide guaranteed income or benefit amounts regardless of actual account performance. They represent the key feature that differentiates annuities from other investment vehicles and account for much of the industry's marketing appeal.

Guaranteed Lifetime Withdrawal Benefit (GLWB) riders allow you to withdraw a specified percentage of a "benefit base" (often growing at a guaranteed annual rate) each year for life, even if the actual account value is depleted. For example, a rider might guarantee 5% annual growth on the benefit base during the deferral period and allow 5% lifetime withdrawals beginning at age 65. If your actual account value runs to zero due to withdrawals and poor performance, the insurer continues the guaranteed payments from its own resources.

These guarantees have real value but come at a real cost. The fee for the rider is charged annually against the actual account value, which accelerates the depletion of that value. In scenarios where the market performs well and your account value remains healthy, the rider's guarantee may never be needed — and you will have paid fees for protection that was never used. The rider's value is concentrated in downside scenarios where markets perform poorly over a long period, making it essentially a form of market risk insurance for the distribution phase of retirement.

Tax Treatment of Annuities

Annuities provide tax-deferred growth: you do not pay taxes on interest or investment gains until you begin taking withdrawals. However, annuity distributions are taxed as ordinary income, not at the preferential capital gains rates that apply to long-term capital gains from direct investments. This tax treatment can be a disadvantage compared to holding index funds in a taxable account, where long-term capital gains and qualified dividends are taxed at lower rates.

When you withdraw money from a non-qualified annuity (purchased with after-tax dollars), the IRS uses a "last in, first out" (LIFO) accounting rule: withdrawals are treated as earnings first (taxable at ordinary rates) until the gains are exhausted, after which further withdrawals return your principal (tax-free). This means early withdrawals from a profitable annuity are fully taxable, and withdrawals before age 59½ are also subject to a 10% early withdrawal penalty, similar to qualified retirement account rules.

Qualified annuities — those held inside an IRA or other qualified retirement account — are funded with pre-tax dollars, and all distributions are taxed as ordinary income, the same as any other traditional IRA or 401(k) withdrawal. The tax-deferral feature of annuities provides no additional benefit inside a tax-deferred account, which is one reason many fee-only financial advisors question the wisdom of placing variable annuities inside IRAs: you are paying the annuity's fee layer for benefits that duplicate those already provided by the IRA wrapper.

When Annuities Make Sense and When They Don't

Annuities make the most sense for people who have a genuine longevity risk concern (long family history, good health), lack other sources of guaranteed lifetime income beyond Social Security, and value peace of mind from income security over maximum expected returns. A simple immediate annuity purchased at retirement with a portion of savings — guaranteeing enough income to cover essential expenses — is a rational, well-documented strategy for retirement income planning that academic research generally supports.

Annuities make less sense as accumulation vehicles for younger investors in the growth phase of their financial lives — the fee layers in most variable and indexed annuities erode returns significantly compared to low-cost index funds in taxable or tax-advantaged accounts. They are also inappropriate for investors who need liquidity, since surrender charges restrict access for years after purchase, and for people who do not have heirs they want to benefit — annuities are often designed in ways that reduce or eliminate death benefits in exchange for the longevity guarantee, which is an appropriate tradeoff only if leaving an estate is not a priority.

Working with a fee-only financial advisor (one who does not earn commissions from product sales) to evaluate annuities is strongly recommended. The complexity of annuity contracts, the opacity of all-in costs, and the commission structure that incentivizes brokers to recommend certain products make unbiased guidance particularly valuable in this area. If an annuity is appropriate for your situation, a fee-only advisor can help identify the most cost-efficient product to achieve the desired outcome.