Annuities may feel like the “new kid on the block,” but they’ve actually been around since Ancient Egypt. Historical evidence shows a prince purchasing an annuity as a stream of income. Since those days, annuities have evolved, and now it seems as though every insurance company offers them—often with multiple versions.
Annuities also appear in retirement plans, and in some cases, high-level executives may receive them as part of a severance package.
The Three Main Types of Annuities
There are three primary types of annuities: variable annuities, fixed index annuities, and fixed annuities. Each has differences, similarities, and potential for confusion. My goal here is to clear up some of that confusion and help you better understand how they may—or may not—fit into your financial portfolio (even if a salesperson tells you otherwise).
Variable Annuities
As the name suggests, variable annuities provide variability. They are the riskiest of the three types. When you purchase a variable annuity, you can invest in what are called sub-accounts, which function similarly to mutual funds. One key difference: mutual funds must distribute realized capital gains to shareholders, while sub-accounts inside a variable annuity do not, since they grow tax-deferred. Tax-deferred growth is one of the main selling points, but rolling over a 401(k) into a variable annuity just for tax-deferred growth doesn’t make much sense—retirement accounts already grow tax-deferred.
So, why use a variable annuity? The main benefit is guaranteed income. When you start withdrawing—also called annuitizing—you receive a guaranteed income stream for a set period or for life, depending on your choice. With variable annuities, the guaranteed income is usually lower, but market growth could increase it. Importantly, you’ll never receive less than the guaranteed income once you annuitize. The income is determined by the value of the contract and at what age you decide to turn on income. The guaranteed amount is backed by the insurance company. The insurance company has to follow strict capital requirements which are monitored by each state’s insurance departments. If an insurance company fails state-charted guaranty associations step in to provide financial protection for the annuity holder. If you are considering purchasing an annuity you should always double check the contract and your states insurance laws to ensure that will be the case.
Like all annuities, variable annuities are insurance products designed to protect, though they come with complexity and risk.
Understanding Fees in Variable Annuities
Variable annuities often come with several layers of fees that you won’t typically see with simpler investments. These include:
- Subaccount Fees – These are essentially the expense ratios of the funds (sub-accounts) inside your annuity. They cover the cost of managing the underlying investments. Just like with mutual funds, the higher the expense ratio, the more of your return is eaten up by fees over time.
- M&E Fees (Mortality & Expense) – This is the insurance fee. It pays for the guarantees built into the annuity, such as death benefits and income protections. These fees often range from 1–1.5% annually and are one of the biggest ongoing costs.
- Rider Fees – Riders are optional add-ons, such as guaranteed lifetime withdrawal benefits or enhanced death benefits. These can be attractive for investors who value security, but they often add another 0.5–1% (sometimes more) in annual fees.
The Trade-Off:
The value of these fees depends on your financial goals. For someone who wants market exposure plus guaranteed income, the cost of riders and M&E fees may be worth the peace of mind. On the other hand, if you are primarily seeking tax-deferred growth, those same fees could be unnecessarily expensive compared to investing in a regular IRA or 401(k).
It’s important to weigh what you’re paying for against what you’re actually using. If you don’t need the extra guarantees, a simpler (and cheaper) product may fit your situation better.
Fixed Index Annuities (FIAs)
If you hear someone brag about a 20%, 30%, or even 50% bonus on their money, they’re likely talking about a Fixed Index Annuity (FIA). A 50% bonus sounds great, but with insurance companies, there’s always a catch.
For example: to get that 50% bonus, you might have to lock your money up for 10 years. During that time, you can typically withdraw only up to 10% annually. Anything above that triggers a surrender charge—a penalty for accessing funds too early.
It’s also important to note: that 50% bonus doesn’t add to your account value, only to your income value or death benefit. So, if you invest $100k with a 50% bonus, your account value is still $100k, but your income value/death benefit becomes $150k. Withdrawals are typically around 6%—guaranteed for life based on the income value.
FIAs also let you tie money to indexes, but options are limited, and growth potential is usually weak. FIAs are typically best for conservative investors seeking guaranteed lifetime income, not for those chasing high returns. If someone promises you “8% growth with no risk,” they may just be trying to sell you a bridge in the Sahara Desert.
Fixed Annuities
Fixed annuities differ from FIAs and are much simpler. A common type is the Multi-Year Guaranteed Annuity (MYGA), which works a lot like a long-term CD at your local bank.
MYGAs typically come in 3-, 5-, 7-, or 10-year terms. For example, if a MYGA offers 5.5% interest for 5 years, you’ll earn that guaranteed rate each year—compounded annually.
Fixed annuities are backed by the insurance company’s general account, which invests conservatively in things like government bonds, high-grade corporate bonds, and mortgage-backed securities.
A MYGA can make sense if you like CDs but want potentially higher rates and the benefit of tax-deferred growth.
Final Thoughts
There’s a lot to understand about annuities, and each insurance company has its own rules, which is why I’ve used the word typically often. A popular saying in the industry is: “Annuities are sold, not bought.”
While some agents push annuities just for commissions, that doesn’t mean they’re always bad. Annuities can fit into an investor’s portfolio—but only if you fully understand the product and its trade-offs.
At the end of the day, speak with a trusted advisor who can guide you through the process and help determine whether an annuity fits your unique situation. If it does, the right type of annuity can provide security and income stability.
Everyone’s financial situation is different, and so is the right solution.