Understanding the Basics of Deferred Annuities

What is an Annuity?

By definition, an annuity is:

  • A fixed sum of money paid to someone each year, typically for the rest of their life
  • A form of insurance or investment entitling the investor to a series of annual sums

Thanks to the kind folks at Dictionary.com.

Explained in my own words: an annuity is an insurance product sold by insurance companies (as explained nicely here by SEC). The primary thing that annuities protect people from is outliving their assets. So, in a nutshell, an annuity is a way to insure against outliving your money.

Fixed, Indexed, and Variable Annuities

The problem with annuities, and why many people shy away from them, is that they’re complicated and there are DOZENS of different kinds. I liken the word “annuity” to the term “used cars”: there are all different makes and models.

You can get stuck with a lemon or you can buy a vehicle that will be reliable and last for the rest of your life. Which one you end up with ultimately is determined by your knowledge of the product and the salesman that you meet with.

While there are two main types of annuities – immediate and deferred – I’m going to stick with explaining the different options of deferred annuities of which there are three main types:

1. Fixed Annuities

2. Fixed-Indexed Annuities

3. Variable Annuities

Fixed Annuities

A fixed annuity is very much like it sounds: it’s an insurance product that offers you a fixed rate of return for a specific period of time. For anybody that’s ever owned a CD, a fixed annuity is very similar.

The downside to a fixed annuity is that (1) the rates aren’t very high and (2) there are serious surrender charges involved when breaking your contract. Most fixed annuity contracts (while they vary) are 5 years in length, so if you were to cash out or request all of your money prior to the end of your contract, then you’ll be assessed a penalty. This penalty is dependent upon the company and particular product (make and model of your vehicle), but they can range anywhere from 1-10% depending on how long into your contract you cash out.

Overall though, for people that are comfortable locking up their money for 5 years (meaning they have substantial liquid assets), fixed annuities may be a decent alternative to CDs. For instance, the best rate you’ll find right now on a 5-year CD is around 1.6% whereas a 5-year fixed annuity will be closer to 2.75%.

Fixed-Indexed Annuities

Fixed-indexed annuities are technically a fixed interest rate product (more-like a fixed annuity/CD as opposed to a mutual fund). These annuities generally offer two benefits:

1. Protection from losing your assets: your value/investment cannot go down due to stock market loss.

2. Participating in part of the stock market’s upside.

Since this is a fixed-interest rate product, you’re investment is not invested in the stock market. However, the interest credited to your account is based on the performance of a particular index (whichever index your annuity allows you to participate in). So, for instance, you can choose the S&P500 and the interest credited to your account will be determined by how that index performs that year.

The tricky part about fixed-indexed annuities is how the insurance companies calculate the actual amount your account gets credited. It gets very complicated but there are 3 main options:

1. Annual point-to-point with cap – it depends on the make/model of the annuity but this is generally capped at 3% in our current interest rate and stock market environment.

2. Participating rates – again, it depends on the annuity company and product but is generally 15%. So if the market gains 20% for the year, you’ll only get credited 3% (or participate in 15%).

3. Monthly Sum – (chart below shows actual performance) this is by far the most complicated method, but also the method that offers the greatest opportunity for gain (especially in a good market). In this particular crediting method, there is generally a CAP on the upside of each month (let’s say 2%/month for example or a total potential of 24% for the year), however there is no cap on the downside in a given month.

So, let’s say in January the market gains 3% of which you’ll get +2%. February was also a good month in which the S&P 500 made 2% of which you were given +2%. However, March was a down month and the market lost 5% where you were credited -5%. …this whole process continues for the entire year and at the end of the year, the totals are summed (hence Monthly Sum) and your account is credited whatever it totals to. In this particular 3-month example, you would have seen a -1% return.

However, here is where the benefit of a fixed-indexed annuity comes into play: despite having a -1% in your Monthly Sum crediting method, your account didn’t lose any value. Go back to benefit #1 that I listed above: your investment cannot go down due to stock market loss. So in this example, you would have gotten credited with 0% and your initial investment would have stayed intact.

With all this in mind, there are some positives and negatives to this type of insurance product:

Pros: (1) no market risk while having some ability to partake in the market’s upside; (2) despite being illiquid, you generally have access to 10% of your investment after the 1st contract year, assuming you’re older than 59 1/2 (called 10% free withdrawals); (3) from all fixed-indexed annuities that I’ve seen, there are no fees associated with them; (4) annual reset (chart below shows example) – whenever your account is credited interest/money in a given year, you cannot lose that money due to market loss in subsequent years.

Cons: (1) limited upside potential, (2) surrender charges (typically 10-year contracts).

The chart below shows the actual performance of a fixed-indexed annuity using the monthly sum crediting method and also illustrates the annual reset prevision well. The RED line is the S&P 500; the DARK BLUE line is the annuity performance; the LIGHT BLUE line is the guaranteed minimum contract value.

deferred annuities image

Variable Annuities

Variable annuities are a totally different beast than fixed and fixed-indexed annuities as they are an actual investment and not a fixed-interest rate product such as the ones previously discussed.

Variable annuities are also an insurance product, however your money is actually invested in mutual funds. Generally, your account balance can (and often will) fluctuate based on the performance of those particular funds. Hence the term “variable.”

These annuities did get a bad name for a long period of time for a myriad of reasons, primarily due to the fact that:

1. There are ridiculous fees associated with them. I’ve yet to see any variable annuity that has less than a 2% annual fee. In addition there are also fees associated with each mutual fund you own.

2. Your balance fluctuates! To counteract this deterrent, some variable annuities now offer an annual reset – much like the fixed-indexed annuities offer – and some even have daily or monthly resets. Depending on the reset terms, there are two options (1) your account can fluctuate but can never go below your initial investment or (2) you have the annual reset and your gains for the past year are locked in (forever…in which case your balance could then never go below your initial investment + gains from the previous year).

Income Riders

Where annuities have really gained their fame and become the popular retirement planning tool that they are is due largely to the income rider option that you can attach to annuity policies. When you attach an income rider, there are typically two values people see on the annual statements: (1) the “accumulation/cash” value which is determined based on how your actual “investment” performs and (2) an “income value” which is ONLY accessible if used as a lifetime income stream (see below).

As has been the theme, each income rider also varies based on the company and product you buy. With that in mind, there are annuity products that have great income riders and should be bought with that purpose in mind, and then there are annuities that have been designed to take advantage of the market’s upside (give you a higher crediting method) but offer terrible income riders.

An income rider generally offers two guarantees:

1. A guaranteed interest rate as long as the money is kept in deferral. Annuity companies are tricky though, so buyer beware! Some companies promote a high interest rate but you’ll find out that it’s simple interest only. However, many offer great compound interest rates; there are a few I deal with that are offering 6.5% (up to 20 years of deferral).

2. A guarantee to pay you a LIFETIME income stream. So, once you’ve stopped deferring the money, you then “turn on” your income rider and start collecting paychecks for the rest of your life. The value of those paychecks is determined by (1) your age at the time of “turning on” the rider, (2) whether or not it will be single or joint payout, and (3) the “income value” that’s in your account.

For anybody that’s interested in an annuity with an income rider, check out this handy annuity calculator.

While I’ve done my best to explain the basics of the 3 main types of deferred annuities, the reality is that they’re complicated. However, annuities with an income rider (and even without) can be a great option for somebody nearing (or in) retirement. Insuring that you can’t outlive your assets is a thing many people are looking for and annuities provide that. Always seek a competent professional when designing your retirement plan and find somebody with the heart of a teacher.

About the Author

By , on Nov 19, 2012
Andy Tenton
Andy is a 30-something New Yorker who turned his financial life around. He took charge of his finances, got out of debt, and is now working his way toward financial success. He is the publisher of WorkSaveLive.com.

How to Become Rich e-Course

Budgeting 101


  1. Holy cow is this ever a comprehensive review! Nice work. I’ll have to bookmark it and go back through in detail. You did a great job of laying out the pros and cons here.

  2. Shilpan says:

    Great write-up, Andy. I never liked annuities because of their fees(normally 2+%). Don’t you think that a prudent investor can get better return(with discipline) to invest in an index fund instead?

  3. Good explanation. I don’t think the legal and interest risk is worth it for most annuities. However, I do like single premium annuities(can also be inflation adjusted). I like the idea of paying a fixed amount and knowing that I’ll receive a certain amount(to cover my basic expenses) for the rest of my life. That allows you to be a little riskier with the rest of your portfolio and everything else is just gravy 🙂

    The Oblivious Investor has some good info on these types of annuities.

    • Andy says:

      Thanks for your comment, Harry! I mostly deal with single premium annuities, so I’ll echo your sentiments. The interest risk is a factor, but it ultimately comes down to what you NEED. If you need 4% to retire comfortably, why take on unnecessary risk for the sake of chasing returns? However, if you need 8% to reach your retirement goals then an annuity may not be the best answer.

  4. CF says:

    I never understood the little details behind annuities but I think I do a little better now. Still a bit confused about income riders – it seems like a condition or a clause that will one day click in, i guess?

    I don’t really think that they fit into our strategy, at least at the moment.

    • Andy says:

      An income rider is an attachment/rider (or a condition if you like that wording best) that is added to the underlying fixed, fixed-indexed, or variable annuity.

      Once you have the rider – which you decide to add at the time of signing the contract – the interest starts building the day the contract becomes effective. Going back to what I mentioned in the post, let’s say you put $100,000 into an annuity with an income rider that has an 8% bonus and 6.5% guaranteed deferral rate: the INCOME VALUE on that annuity will grow to a little over $200k in 10 years. At that point, you can decide to defer it longer (while still getting the 6.5%) or you can decide to start drawing the income. If you decide to take the income then they’ll determine the payment amount based on that income value of $200,000. If you’re 65 years old at the time you start drawing income, then (depending on the company) they may pay you 5% if you’re single or 4.5% if you’re married. Therefore you’d get $10,000/year for life or $9,000/year as long as either of you are alive, respectively.

      Depending on the contract you can defer up to 15 or 20 years on some, and you can decide to start/stop the income whenever you choose (assuming the youngest person, in “joint” life cases, is older than 59 1/2).

      Only moderately confusing…I know. 🙂

  5. Great Info Andy.. I am going to bookmark this post for a few years down the road as we put together our investment strategy around retirement/wealth building… The fixed annuities certainly seem like a decent option once your liquid needs are covered…

  6. Thad P says:

    Exceptionally thorough and clear description of annuities. Thanks for a great post.

  7. funancials says:

    I think it’s funny that so many CD investors shy away from Fixed Annuities, even though they’re nearly identical. I actually prefer fixed annuities to CDs. A 5-year Fixed Annuity will typically pay more interest than a 5-year CD. You can also add some riders which guarantee your principal back whenever you want it (making it liquid) or offering free withdrawals (maybe 10% per year). The problem is 1. people aren’t educated -or- 2. they are fixed on FDIC insurance. Not realizing that insurance companies have insurance for insolvencies as well.

    My thoughts are VAs change daily. In specific cases, they are beautiful and work wonderfully for someone worried about outliving their money. It’s the general concept I don’t like. “Let me give you my money, then I’ll pay you to give it back to me.”

    • JT says:

      Funancials, I agree 100%.

      Andy did an excellent job here of explaining how annuities can be pretty awesome investments. I love the idea of an income rider as longevity insurance because, frankly, we have no idea how long we’re going to be on this planet. I see annuities as intelligent reverse life insurance, in that an income rider protects us from living too long. Also, because it’s a return of principal in most cases, they’re great for tax purposes for older folks.

  8. Wow this is so thorough I need to re-read it just to digest it all! Thanks for this. I don’t think I really understood what annuities are.

    • Andy says:

      Well, annuities are simply another type of investment. They give you the potential to earn money in various ways:

      A fixed annuity acts very much like a CD in that it’s going to pay you a certain percentage each year you leave it invested. Once the term is over, then you can go on as you please and invest in something else.

      A fixed-indexed annuity is an “investment” that allows you to take part in the upsides of the market while not ever having to worry about losing money.

      A variable annuity is much like mutual funds in the fact that you’re invested in the stock market (typically in mutual funds themselves). They offer the same up-side as the market but have provisions which allow you to not lose your initial investment and sometimes allows you to lock in gains after each contract year.

      With each of these, you can attach various riders which perform different functions. The most common rider is the “income rider” which guarantees (1) the lifetime paychecks (exactly like a pension, the only difference is that if there is money left after you die it typically goes to your beneficiaries), and (2) most guarantee a specific interest rate that you can earn while your premium (“investment) is in deferral (the caveat here is that this “income value” means nothing to you other than determining how much your lifetime paycheck will be).

  9. I am beginning to understand annuitites a bit better after a couple of year of reading information off and on, but I don’t feel they are a good fit for us now, but maybe when we retire?

    • Andy says:

      It really depends on your age (I’m not sure how old you are) and what your goals/fears/risk tolerance are. For some those that don’t mind risk, an annuity doesn’t make sense even when in retirement: if you have a substantial amount of assets and have no fear of outliving your money (or losing money to a market downturn), then annuities would have very little value to somebody like that.

  10. I won’t even pretend that I completely understand it after reading your post. This is a complex topic for me to digest but your post makes a good starting point. The thing is, I hear about annuities ALL THE TIME and never understood what the heck that was. I’m still a bit confused as to why annuities pay more than CD’s, is that because you can’t withdraw from it early? So this is not a good investment for a younger generation?

    • Andy says:

      It’s a lot easier to explain them with visuals, but I try my best! 🙂

      So, a fixed annuity pays out more because the insurance companies invest a portion of your money in aggressive investments. By law, they have to hold 87.5% of your money in a conservative investment (this may be money market-type investments or immediate bonds), but the other 12.5% they play with and buy options. So, that’s why a fixed annuity would pay more than a CD (because they’re investing a portion of your money aggressively and have figured out that they can still offer you a higher interest rate and make money while doing it). They know they get to hold onto your money for 5 years and they’re able to invest 12.5% of it however they want – and they pay some people A LOT of money to be very good at buying/selling options.

  11. Well written and very informative Andy as I was able to learn something new today. Financial literacy here I come… cheers Andy. Like Kurt I was thinking the same thing what happens if they go bust? What happens if any insurance company goes belly up? Mr.CBB

  12. Very informative Andy, much appreciated. I think you’ve explained this for me before, but thanks for answering again if you don’t mind: What happens if the insurance company from which I purchase my annuity goes bust? There’s an organization backing annuities, or something like that, yes?

    • Andy says:

      Definitely a great question. So, the most important part of choosing an annuity is finding a stable company. What we look for is the credit rating and something called “solvency ratio.” Having 100%+ solvency ratio is very important as that basically is the ratio between cash on hand versus total assets on the books (so, if everybody cashed in their annuity tomorrow, could they pay everybody back?).

      I’ve talked to other professionals a lot about this, but I can’t remember a large life insurance/annuity company that totally busted. Generally what we see (with the reputable ones) is another company will come in and buy them out (while assuming the contracts).

      Saying all of that, if the company didn’t get bought out, then there is insurance provided by the state. I believe the minimum is $100,000 per contract. For instance, the organization here is called the Missouri Insurance Guaranty Association and they insure up to $100k per contract.

      • funancials says:

        Your reply here is spot on. I know that in North Carolina (my home state), no one has ever lost their money because of an insurance company “going bust.” Each insurance company pays into the Guaranty Fund (like Andy said)…much like banks pay into the FDIC.

        • Andy says:

          Exactly right! This is a big deterrent for some people that I meet with and it’s primarily due to ignorance. I like the facts and the reality is that the majority of major life insurance companies get bought out…and in a worst-case scenario there is always the insurance protection.

  13. This is great info. I had no idea. Thanks Andy!

  14. Nice review Andy! Let’s say I buy a $500,000 annuity and die next month. What happens to the $500,000?

    Which type of annuity, if any would you recommend for someone like me, in this current interest rate environment. What type of interest return do you think I can get?

    BTW: wan’st this the post you said you wanted to GP on FS a while back? I forget.



    • Andy says:

      When we talked about doing a GP, you had asked me to write it in how an annuity could be beneficial to somebody that’s younger (in their 30s or 40s). Unfortunately I don’t think annuities are the best for people of that age group; in-fact, there are many annuities that won’t even allow you to open a contract unless you’re over age 50. That’s really why I never followed through on the GP…sorry for the miscommunication!

      To answer your questions:

      If you die, the money will go directly to your beneficiaries. Basically, the calculation would be: Your Investment + Bonus (generally there is a bonus for new contributions within the first year) + Interest Earned – Withdrawals – Fees (if applicable) = Accumulation Value (or the value that would go to your beneficiaries).

      The answer to your other question is much more complicated and ultimately depends on what you’re trying to accomplish. If you want lifetime income, then getting something with an income rider and deferring it for 15-20 years would be the best (assuming you’re 39…which I believe you’re a little younger). The other problem with annuities is that they’re a tax-deferred investment and they basically become a retirement account even if you fund it with non-qualified assets; therefore, you’d get penalized if you withdrawal money prior to 59 1/2 (which is part of the reason why they’re not the best choice for younger people).

      As far as what you can earn with an income rider will depend on the state you live in will (you’d also have to see what’s available for your age). There is one I know of right now (in Missouri…not sure if it’s available in CA) that gives an 8% bonus and 6.5% compound interest each year in deferral.

      If you’re simply looking for protection and moderate growth then a fixed-indexed annuity (without an income rider) might be best. Based on historical returns this might get you 3.5-5.5% or so over a 10-year period. The benefit here is that you’re “tied” to the market index, get a portion of their gains (as I mentioned in the post), but you’d never lose money even if the index lost money in a given year. Furthermore, there are no fees tied to these types of annuities. The only caveat is that your money is tied up for 10 years (there are 5-year contracts as well, but they don’t offer as much upside potential); the surrender charge typically decreases throughout the 10-year period, but it may start around 10%.

      On the flip side, if you believe the market is going to do well over the next 10 years, then a variable annuity might be a viable option…despite their fees. They give you the potential for much higher returns, but when you’re paying 3-4%/year in fees, you need for the market to perform well for it to make sense.

Leave a Reply

Your email address will not be published. Required fields are marked *

Disclaimer and Stuff

The articles are written by personal finance enthusiasts (not certified professionals) based on their personal experience. What works for them may or may not work for you, and you should always consult a financial advisor before making important financial decisions.

In accordance with FTC guidelines, we disclose that we have a financial relationship with companies mentioned in this website. This may include receiving access to free products and services for product and service reviews and giveaways.

Any references to third party products, rates, or websites are subject to change without notice. We do our best to maintain current information, but due to the rapidly changing environment, some information may have changed since it was published. Please do the appropriate research before participating in any third party offers.

For additional information, please review our legal disclaimers and privacy policy.