How Annuities Work: Types, Fees, and When They Make Sense

$265 Billion in Annuity Sales in a Single Year

U.S. annuity sales reached $265 billion in 2022, the highest annual total ever recorded, according to LIMRA. Sales climbed further in 2023, surpassing $310 billion. Rising interest rates made fixed annuities more attractive, and an aging population increasingly sought guaranteed income they could not outlive. Yet annuities remain one of the most misunderstood financial products. Their fee structures are opaque, their contracts run dozens of pages, and the wrong type purchased at the wrong time can lock up money for years while generating mediocre returns.

Understanding the mechanics matters before signing anything.

The Basic Structure Across All Types

Every annuity involves a contract between an individual and an insurance company. The buyer contributes money—either as a lump sum or through periodic payments—and the insurer promises future income. The two main phases are:

Accumulation phase: Money grows inside the contract, tax-deferred. No income taxes are owed until withdrawals begin.
Annuitization (payout) phase: The insurer converts the accumulated value into periodic payments—monthly, quarterly, or annually—for a specified period or for life.

The tax-deferral is a key selling point. Earnings compound without annual tax drag, similar to a traditional IRA. Withdrawals before age 59½ typically trigger a 10% IRS penalty in addition to ordinary income tax.

Four Main Annuity Types Compared

Type	How Returns Are Determined	Risk Level	Typical Annual Fees	Best Suited For
Fixed	Insurance company guarantees a stated interest rate	Low	0%–0.5%	Conservative savers seeking predictable returns
Variable	Returns depend on performance of chosen investment subaccounts	Moderate to high	2%–3.5%	Investors comfortable with market risk
Fixed indexed	Returns linked to a market index (e.g., S&P 500) with caps and floors	Low to moderate	0.5%–1.5%	People wanting some market upside with downside protection
Immediate	Lump sum converted to income payments starting within 12 months	Low	Built into payout rate	Retirees needing income now

Fixed Annuities in Detail

A fixed annuity works like a CD issued by an insurance company. The insurer guarantees a minimum interest rate—typically 3% to 5.5% in the current rate environment—for a set period (3, 5, 7, or 10 years). Principal is protected from market losses. The trade-off is limited upside. When the stock market returns 15% in a year, the fixed annuity still pays its guaranteed rate.

Variable Annuities in Detail

Variable annuities allow the buyer to invest in subaccounts—essentially mutual fund equivalents within the annuity wrapper. Returns fluctuate with market performance. The buyer bears investment risk. Losses are possible. Variable annuities carry the highest fees of any annuity type, often exceeding 3% annually when all charges are combined.

The Fee Layers That Erode Returns

Annuity fees are notoriously complex. Multiple charges stack on top of each other, and each is disclosed in different sections of the contract.

Fee Type	Typical Range	What It Covers
Mortality and expense (M&E)	1.0%–1.5% annually	Insurance company's risk and profit margin
Administrative fees	0.1%–0.3% annually	Record-keeping and account maintenance
Investment management fees	0.5%–1.5% annually	Subaccount fund management (variable annuities)
Surrender charges	7%–10% declining over 6–8 years	Penalty for early withdrawal from the contract
Rider fees	0.5%–1.5% annually	Optional benefits like guaranteed income riders

A variable annuity with a guaranteed lifetime withdrawal benefit rider can easily carry total annual fees of 3% to 4%. On a $200,000 investment, that's $6,000 to $8,000 per year before any returns are realized. The fees compound against you just as returns compound for you.

Surrender Charges: The Exit Penalty

Most deferred annuities impose surrender charges for early withdrawals, typically lasting 6 to 10 years. A common schedule starts at 7% in year one and declines by 1% annually, reaching 0% in year eight. Most contracts allow penalty-free withdrawals of 10% of the account value per year.

The surrender period is the single biggest liquidity risk. Money locked in an annuity cannot be accessed for emergencies, opportunities, or changed circumstances without paying a substantial penalty. This illiquidity is the price of guaranteed income.

When Annuities Fit a Retirement Plan

Annuities serve a specific purpose: longevity insurance. They guarantee income that cannot be outlived, which addresses the central fear of retirement planning—running out of money. For someone who has already maximized their 401(k) and IRA contributions, has an adequate emergency fund, and wants a predictable income floor in retirement, a fixed or immediate annuity can fill that role.

Retirees without pensions who need guaranteed monthly income to cover essential expenses
People in their 60s or 70s converting a portion of savings into lifetime income
High-income earners who have exhausted other tax-advantaged accounts and want additional tax deferral
Individuals with a family history of longevity who face a longer-than-average retirement

When They Don't

Annuities are poorly suited for several common situations:

Young investors with decades until retirement—tax-advantaged accounts like 401(k)s and Roth IRAs offer better growth with lower fees
People who may need access to their money within the surrender period
Anyone who hasn't first built an emergency fund and paid off high-interest debt
Investors already receiving a pension that covers essential expenses
Those in low tax brackets who gain little benefit from tax deferral

The financial services industry earns substantial commissions on annuity sales—typically 4% to 8% of the premium for variable annuities. That commission structure creates incentives to sell annuities to people who do not need them. The Department of Labor's fiduciary rule (proposed, revised, and challenged in courts repeatedly since 2016) attempted to address this conflict of interest.

Annuities are tools. They solve a specific problem well—turning savings into income that lasts a lifetime. The question is whether that problem is yours, and whether the cost of the solution is justified by your circumstances.

This article is for informational purposes only and does not constitute financial advice.