What Is an Annuity?
A contract that turns a lump sum into guaranteed income — with fees so high they make hedge funds look cheap.
2-3%
Typical Annual Fees
5-8%
Surrender Charges
5-10 yr
Lock-Up Period
What Is an Annuity?
An annuity is an insurance product — not an investment. You give an insurance company a lump sum of money (or a series of payments), and in return they promise to pay you a stream of income, either immediately or starting at a future date. The income can last for a set number of years or for the rest of your life.
The appeal is simple: guaranteed income you cannot outlive. In a world where pensions have largely disappeared, annuities offer a way to create your own personal pension. The insurance company takes on the risk that you will live longer than expected — and in exchange, they keep whatever is left if you die early.
The problem is equally simple: the fees are enormous. Variable annuities can charge 2-3% per year in combined fees, plus surrender charges of 5-8% if you try to get your money back in the first decade. Insurance agents earn commissions of 5-7% for selling annuities, which is why they push them so aggressively.
Types of Annuities
Fixed Annuity
Acceptable for retirees who need guaranteed incomePays a guaranteed interest rate for a set period, similar to a CD. Simple, transparent, lowest fees of all annuity types. Rates are typically competitive with CDs. The only annuity type worth considering for most people.
Variable Annuity
Avoid — high fees destroy returnsYour money is invested in sub-accounts (similar to mutual funds) and your returns depend on market performance. Sounds good in theory, but total fees of 2-3% per year gut your returns. A low-cost index fund in a Roth IRA achieves the same tax-deferred growth at 1/100th the cost.
Indexed (Fixed Indexed) Annuity
Be very skeptical — complexity hides costsReturns are linked to a market index (like the S&P 500) with a guaranteed floor (you cannot lose money) and a cap on gains (typically 5-10% per year). The insurance company keeps any gains above the cap. The complexity of the crediting formula makes it nearly impossible to compare to simple investments.
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The Hidden Fees
| Fee Type | Typical Range | What It Means |
|---|---|---|
| Mortality & Expense (M&E) | 1.00% - 1.50%/yr | The insurance company's profit margin — charged regardless of performance |
| Administrative Fee | 0.10% - 0.30%/yr | Covers record-keeping and compliance costs |
| Sub-Account Fees | 0.50% - 1.00%/yr | The expense ratios of the underlying mutual fund-like investments |
| Rider Fees | 0.25% - 1.00%/yr | Optional add-ons like guaranteed minimum income or death benefits |
| Surrender Charge | 5% - 8% (declining) | Penalty for withdrawing money in the first 5-10 years |
Total annual cost of a typical variable annuity:
2.00% - 3.50% per year. On a $500,000 annuity, that is $10,000 - $17,500 annually in fees — before you earn a single dollar of returns. A comparable index fund charges $150 per year.
When to Buy an Annuity (and When Not To)
Consider an Annuity If...
- +You are retired and need guaranteed income you cannot outlive
- +You have maxed out ALL other tax-advantaged accounts first
- +You have no pension and want to create one
- +You choose a simple fixed annuity (not variable or indexed)
- +You are working with a fee-only fiduciary advisor (not a commissioned salesperson)
Avoid an Annuity If...
- -You are under 50 — you have decades for index funds to compound
- -You have not maxed out your 401(k), IRA, and HSA
- -An insurance agent is pushing you to buy one (they earn 5-7% commission)
- -You want liquidity — surrender charges lock your money for 5-10 years
- -You do not understand the fee structure — if confused, walk away
Glen's Take
Annuities are one of the most oversold financial products in America. The commissions are so large that they corrupt the advice.
When an insurance agent recommends a variable annuity, ask them how much commission they earn on the sale. The answer is typically 5-7% of your entire investment — $25,000 to $35,000 on a $500,000 annuity. That is their incentive. Not your retirement security.
If you genuinely need guaranteed retirement income, a simple fixed annuity from a highly rated insurance company can make sense. But for wealth building? A Roth IRA with low-cost index funds will almost certainly leave you wealthier — and you will always have access to your money.
Frequently Asked Questions
What is an annuity in simple terms?
An annuity is a contract with an insurance company where you give them a lump sum (or series of payments) and in return they promise to pay you a regular income stream — either immediately or starting at a future date. Think of it as buying a personal pension. You trade a pile of money for guaranteed monthly checks.
What are the different types of annuities?
There are three main types: (1) Fixed annuities pay a guaranteed interest rate, like a CD from an insurance company. (2) Variable annuities let you invest in sub-accounts similar to mutual funds — your returns depend on market performance. (3) Indexed annuities tie returns to a market index like the S&P 500, with a floor (you cannot lose money) and a cap (your gains are limited).
What are the biggest disadvantages of annuities?
High fees are the biggest issue. Variable annuities can charge 2-3% per year in combined fees (mortality charges, administrative fees, fund expenses, rider fees). Surrender charges of 5-8% apply if you withdraw money in the first 5-10 years. Gains are taxed as ordinary income (not capital gains). And annuities are not FDIC insured — they are backed by the insurance company's financial strength.
When does an annuity make sense?
Annuities can make sense in two situations: (1) You have maxed out all other tax-advantaged retirement accounts (401k, IRA, HSA) and want additional tax-deferred growth. (2) You are retired, have no pension, and want guaranteed income you cannot outlive. For most people under 50, low-cost index funds in a Roth IRA are a better choice.
Are annuities a good investment?
For most people, no. The high fees, surrender charges, and tax treatment make annuities inferior to low-cost index funds for wealth building. However, for retirees who prioritize guaranteed income over maximum returns, a simple fixed annuity (not variable, not indexed) can provide peace of mind. The key is avoiding the complex, high-fee products that insurance agents love to sell because of the large commissions they earn.
Recommended Resources
Tools & books I actually use and recommend
Interactive Brokers
Low commissions, global market access, and professional-grade tools. This is where I hold my positions.
Open an AccountA Random Walk Down Wall Street
Burton Malkiel's classic case for index investing. The book that convinced millions to stop stock-picking.
View on AmazonThe Intelligent Investor
Ben Graham's timeless guide to value investing. The book Warren Buffett calls "the best investing book ever written."
View on AmazonSome links above are affiliate links. I only recommend products I personally use. See my full disclosures.
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