Why annuities are often misunderstood - and what they actually do

A stable retirement depends on having income that continues no matter how long you live. A traditional 401(k) helps you build savings, but it is only one component of a retirement strategy. Eventually, those savings still need to generate reliable income. An annuity is designed to help solve that problem by converting a portion of your savings into guaranteed monthly payments while the rest of your portfolio can stay invested.

"Retirement, in practice, is about replacing a paycheck," said Tom Buckingham, FSA, MAAA, Chief Growth Officer at Nassau Financial Group. "That is the gap. Annuities are one of the few tools designed specifically to solve for that and the only to do it for life."

For many Americans, annuities still carry a complicated reputation. They are often associated with high fees and confusing terms. Some of that criticism is fair. But annuities also serve a role in retirement planning that traditional investment accounts do not. To better understand how annuities work and where they fit into retirement planning, we spoke with Buckingham, whose work on retirement income has appeared in Barron's, MarketWatch, and Kiplinger.

What Annuities Actually Are

An annuity is a contract with an insurance company. You contribute money either through a lump sum or a series of payments, and in return the insurer agrees to provide income either immediately or at a future date.

"The focus has been on building a balance, not on converting that balance into income," Buckingham said.

The simplest way to think about it is that a 401(k) helps build the pool of money, while an annuity helps turn part of that pool into a paycheck.

"A 401(k) gives you assets. Social Security gives you a base income. Neither fully solves for longevity risk," Buckingham said.

Longevity risk is the possibility of outliving your savings.

"An annuity converts a portion of savings into lifetime guaranteed income, effectively creating a personal pension," Buckingham said.

That pension comparison matters because most private-sector workers no longer have one. Many retirees are now expected to manage withdrawals from investment accounts on their own while also navigating market volatility and inflation throughout retirement.

Most private-sector workers no longer have one. Today, most retirees manage withdrawals from their investment accounts on their own while navigating market volatility and inflation.

"An annuity converts a portion of savings into lifetime guaranteed income, effectively creating a personal pension."

The Main Types of Annuities

There are several types of annuities, and they do not all work the same way. The first distinction is immediate versus deferred annuities.

An immediate annuity begins making payments shortly after purchase, usually in exchange for a lump sum. A deferred annuity allows money to grow before income payments begin later.

Within deferred annuities, three structures come up most often:

• Fixed annuities offer a guaranteed interest rate and predictable payments. They tend to carry lower risk, although growth potential is usually more limited.
• Fixed indexed annuities connect returns to a market index like the S&P 500 while still offering downside protection. If the market declines, losses are generally limited, although gains are usually capped.
• Variable annuities function more like investment accounts. Returns rise and fall with market performance, which means more growth potential but also more risk.

One simpler option is the single premium immediate annuity, or SPIA. A retiree contributes a lump sum, payments begin shortly after, and those payments continue for life.

How much income an annuity provides depends on factors like age, interest rates, and the product itself.

What Guaranteed Income Changes

According to Buckingham, guaranteed income can help retirees make more consistent financial decisions during periods of market volatility.

"When essential expenses are covered by guaranteed income, it can provide greater financial stability and predictability," he said. "That foundation can help reduce sensitivity to market volatility and support more consistent decision-making and spending over time."

For many retirees, part of the appeal is the peace of mind that comes from knowing essential expenses are covered regardless of what the market is doing.

The Tradeoffs

Annuities are not risk-free.

Liquidity and Access to Your Money

Many annuities include surrender periods that penalize early withdrawals. If your financial situation changes unexpectedly and you need access to that money, it may be expensive to get it out.

Unlike bank accounts, annuities are not FDIC insured. Instead, protections depend largely on the financial strength of the insurer, along with limited protections from state guaranty associations if an insurer becomes insolvent. State guaranty associations were created to help protect policyholders and continue coverage in the event of an insurer insolvency, according to the National Association of Insurance Commissioners' Life and Health Insurance Guaranty Association Model Act.

Inflation and Fixed Payments

Inflation is another important consideration, particularly with fixed payments. Two thousand dollars a month is still two thousand dollars a month whether it is 2025 or 2040. What that money actually buys you over time is a different story. Some annuity products offer riders or structures designed to help offset inflation risk, but those often come with additional costs or tradeoffs.

Fees and Commissions

Fees can become significant depending on the product. Variable annuities in particular may include contract fees and investment management fees that reduce overall returns.

Commissions are one reason annuities sometimes receive criticism. Some annuity products pay commissions to advisors or sales representatives, which can create potential conflicts of interest. That does not automatically make annuities bad products. But it does make it important to understand what you are buying and who is recommending it.

Who Annuities May Make Sense For

For many retirees, annuities are not meant to replace an entire portfolio.

"First, this is rarely an all or nothing decision," Buckingham said. "You are typically solving for a portion of income, not the entire portfolio."

Many retirees use annuities to help cover essential expenses while leaving the rest of their portfolio invested for growth, flexibility, or future spending needs. Annuities may make more sense for retirees approaching or already in retirement who want more predictable income and do not expect to need immediate access to a portion of their savings. They may make less sense for younger investors still focused primarily on long-term growth or for retirees who already have enough guaranteed income from pensions or other sources.

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This story was originally published May 26, 2026 at 9:33 AM.