What is an Annuity?

Annuities have been an option for retirees and accumulators for a long-time. A very long time. The first annuity can be traced back to the 1500’s when Charles V of the Hapsburg regime created contracts to sell to citizens that carried the promise of a fixed interest payment for the life of the contract holder (1). You’d have to think he probably made out pretty well on that deal, as the average life expectancy back then was what, 40 years old?

Annuities have a very specific divide with consumers, they are either loved or hated, and it’s seemingly because, depending on the product, they can be difficult to understand. Educators, in my experience, are drawn to annuities because they mirror the type of cash flow they are used to – consistent and predictable. My objective here is to explain annuities at an introductory level and give some insight on how to properly assess them.

What is an Annuity?

In short, an annuity is an insurance product. An insurance company sells a contract to the individual – the annuitant – that includes a promise to pay the annuitant a certain amount of money, over a certain amount of time, based off of the investment the annuitant has made. Other features can be included in these contracts, including death benefits, contract step-ups, and more. These enhancements to your contract are called riders, and they can be added on to each annuity product as the annuitant sees fit, with a level of added cost.

Annuities: The Pros

The pros to annuities are set in the foundations of their existence. They offer guaranteed income and tax deferred growth. Here’s an example:

  • a. An individual, we’ll call him Tom, may take a $500,000 investment and buy an annuity contract. For the sake of keeping it simple, let’s assume Tom purchases a single premium immediate annuity (SPIA) with his $500,000. The insurance company will quote Tom a rate of payment based off of his investment. We’ll say this one is 5% annually. Using this, Tom can expect to receive 5% of $500,000 in annual payments for a period time (usually the rest of his life). Tom buys this contract and annuitizes it (meaning he’s locked in the payment schedule perpetually). Tom will now receive $25,000/year from this annuity for the rest of his life.
    • The SPIA is the least complicated option for the consumer and the easiest to explain. Where it becomes more complicated is the purchase of an annuity, without the intention of annuitizing it for many years.
  • Annuities also grow tax deferred. No matter what takes place with the investments inside the contract – dividends, interest payments, capital gains – you do not pay taxes on the money until you withdraw it. However, unlike an IRA or qualified plan, there’s no contribution cap. Everyone is capped on how much they can put into an IRA or qualified plan, but there’s no limit as to what you can put into an annuity. Initially, this sounds like a great opportunity to plug cash into an annuity and let it grow tax deferred! However, there’s more to that than meets the eye.

Annuities: The Cons

  • Evaluate. How do you know which annuity is right for you? As a consumer you can choose between any of the following: variable annuity, fixed annuity, indexed annuity, fixed index annuity, immediate annuity, or deferred annuity. Each type of annuity will then present itself with a handful of payment schedules and riders, and it is critical that you understand each.
  • The fees. These guarantees don’t come with just a handshake. If you want guaranteed income, you have to pay for it. This article from Fidelity points out what to look for and what questions to ask when shopping for an annuity. It’s fair to assume your annuity costs will range from 1.5% – 3% annually on your investment.
  • Access. Your access to the principal. You’ve invested a large portion of your money into an annuity and have decided to begin taking the annual income. Yet you need to access some of that investment to pay for other expenses. Depending on the contract you’ve agreed to with the insurance company, that principal can be extremely difficult to gain access to, or it will come with penalties in the form of extra costs. Yes, you’re getting the income, but the accessibility of the funds you’ve worked hard to accumulate can be difficult.
  • Taxes. I mentioned earlier the opportunity to fund an annuity with a lump of cash you’ve already paid taxes on. Sounds like a tax efficient idea. Not necessarily.
    • Example: Let’s say you fund an annuity with $500,000 of after-tax money – maybe it’s from your bank account, or a brokerage account or an inheritance. You buy an annuity contract and let it grow for 10 years before you annuitize it. That will grow tax free (not fee free, however) and let’s say it grows at a rate of 3% over 10-years, making your balance when you’re ready to annuitize $671,958. When you begin to receive income you will need to determine your exclusion percentage in order to correctly forecast what income is taxable and what is a return of basis. You’ve added complexity with the exclusion percentage, and now you’re adding ordinary income to your life, too. Payments received from an annuity are taxed as ordinary income, never as capital gains. So the gains you’ve earned in your annuity are not taxed that way – they’re taxed at a higher rate.
  • Conflict. It’s no secret, it pays to sell annuities. There is a cost to doing business everywhere, I’m certainly not disputing that, and I have recommended annuities to more than one person in my career, but it’s important to understand who you’re buying an annuity from and why it’s being recommended. I have spoken at length on the importance of working with a fiduciary and this scenario is no different. Not every advisor is paid a commission – nor is there conflict with every recommendation – further driving home the importance of understanding what questions to ask and ensuring the product aligns with what you are trying to accomplish.

How do I assess what’s right for me?

An annuity provides something very similar to the paycheck educators have received over the course of their life, and I am very cognizant as to why they are attractive. However, a lot of items must be covered before deciding to purchase a product. A comprehensive financial plan that outlines a variety of income scenarios is the best place to start. Work with your fiduciary to understand how you can effectively and efficiently stream your income in retirement.

  • How can you establish buckets of investments to provide for your income needs, while keeping your liquidity?
  • How can you plan to receive your income as tax efficiently as possible?
  • Do you have an income stream and a long-term healthcare goal established?
  • How does social security and/or a pension fit in with your plan?

These are all questions that need to asked and answered, by your financial planner, before deciding what is best for you.

[1] Smith, B. Mark, A History of the Global Stock Market (Chicago: University of Chicago Press, 2003), p. 14.


Our team of wealth advisors here at BerganKDV are fee-only fiduciaries who are dedicated to helping you navigate all areas of your financial life. Want to learn more about what we can do for you? Start here.


The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

The views expressed are those of BerganKDV Wealth Management. They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm. Investment advisory services and fee-based planning offered through BerganKDV Wealth Management, an SEC Registered Investment Advisor.


CATEGORIES: Wealth Management
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