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When planning for retirement, many Americans forget to plan for one of the most important risksthe risk of "living too long" and running out of money. Increases in life expectancy have resulted in people often spending twenty to thirty years (or more) in retirement. Women especially are in danger of experiencing this gap between length of life and retirement resources because, statistically speaking, they live longer than men. There is one investment product that is designed to protect against this riskan annuity.

What is an annuity?

An annuity is a contract sold by a life insurance company that guarantees a stream of payments to the buyer (the annuitant ) that begin at a specified time, often at retirement. With an annuity, the annuitant is literally buying a future income. There are different types of annuities. Deferred annuities are purchased either with a single payment or by regular premiums during the annuitant's working life with the specification that the funds are to be used at some future date. Immediate life annuities are bought at the time of retirementthe purchaser makes a single payment to an insurance company, which invests the money and begins to send the annuitant regular payments immediately.

Annuities provide a regular income that cannot be outlived. Monthly, semiannual, or annual payments are made until the annuitant dies. Therefore, an annuity provides a form of security that investments in stocks or bonds can't. Some annuities also name another person, such as a spouse, to continue getting income payments after the annuitant dies.

An annuity can be either fixed or variable. A fixed annuity has payments that are specified in the contract and usually remain the same, while a variable annuity has payments that go up and down based on underlying investments in the stock market or other securities.

There are also special kinds of annuities that are sold by charitable organizations that let an annuitant withdraw money in a lump sum. These annuities pay income only for a limited time.

Unfortunately, there is no magic formula for determining how much income is needed after retirement. Most financial planners agree that to maintain the same standard of living after retirement as before, an individual will need an annual income that is roughly 70 percent of his or her gross income before taxes while working. But this is only a rough estimate. Each person needs to refine it for his or her own situation.

Nor is it possible to know how long a person will need a retirement income. Life expectancy figures exist, but while they are useful for calculating what will happen with large numbers of people, they don't help in calculating how long an individual will live. Actuaries say longevity is a "moving target." For example, an actuarial table might indicate that people 65 years old can expect to live another twenty years, or to age 85. However, of that group, those who live to 75 can then expect to live to age 87.5; and those who live to 85 can expect to live to 91.5. And, since women tend to live longer than men, 65-year-old women are 8 percent more likely than 65-year-old men to reach age 80, and 81 percent more likely to reach age 90. Because this is true, married women usually survive their spouses, often with much less income than before.

How does inflation affect retirees?

The price of almost everything will probably go up every year. This is the effect of inflation, a major risk that nobody can predict. In the 1990s, annual inflation was about 3 percent down from the 1980s, when inflation was about 5 percent, and the 1970s, when it was about 7 percent. Inflation can make a big difference in what a worker will be able to buy after retiring. Table 1 provides examples of how inflation can diminish purchasing power.

Most private pensions are not adjusted every year to provide enough money to counteract the effect of inflation. Many large public employers, such as the U.S. government and some state and local governments, do adjust the amounts of their employees' pensions every year for inflation, and Social Security automatically makes cost-of-living adjustments (COLAs). If most of an individual's retirement income will not be automatically adjusted for inflation, the effect of inflation should be considered a serious financial risk and taken into consideration when planning for retirement.

Many people believe they should take no risks with investing their retirement funds, so they keep their money in Treasury bills, certificates of deposit, or money market funds, which they regard as safe. These choices may not be the best alternatives in the long run, however, because such conservative "cash" investments produce the smallest net return after inflation. Historically, stocks offer the highest potential to keep ahead of inflation, as shown in Table 2.

While past results do not guarantee future performance, stocks can play an important long-term role in an investment strategy (unless the future is totally unlike the past). Other ways to fight inflation include annuities or pensions with automatic annual cost-of-living increases or variable annuities invested in a stock market portfolio. Variable annuities require very careful shopping, however, because they can have high costs and fees.

Why buy an annuity?

An annuity allows conversion of all or part of the annuitant's retirement savings to a guaranteed stream of lifetime income. Annuities are not for everyone, but they can be very helpful in securing retirement income by letting an insurance company bear the risk that the annuitant will live many more years after retirement. No matter how long the annuitant lives, the insurance company will send payments every month, quarter, half-year, or year. There is a price for this security, however. Once the annuity contract is signed, the annuitant cannot take assets out of the insurance company in a lump sum. The amount of income an annuitant will receive is based on a number of factors, including age, sex, the income option selected, and interest rates at the time of purchase. The income payments can stay level or gradually increase to offset inflation.

Alternatives to annuities

Though alternative investments are less dependable than annuities, they allow the retiree more control over his or her money. Rather than buy an annuity, a retiree could make systematic withdrawals from savings and investment income. To do that, a retiree must estimate how much he or she can afford to spend each year over a lifetime. But since nobody knows how long they will live, how well their investments will do, or how much inflation will fluctuate, they must rely on educated guesses. Even if a person's economic assumptions hold up over the long run, investment returns may fluctuate greatly from year to year. And, currently, after age seventy and one-half, withdrawals from funds invested in a 401(k) or traditional IRA must also satisfy complex IRS rules for minimum annual withdrawals. An immediate annuity automatically satisfies such rules.

It is important to remember that an annuity is a product sold by an insurance company, and part of the purchase price goes to cover insurance company expenses. These expenses, called loadings, cover the insurer's marketing and administrative costs.

Insurers use conservative assumptions for longevity. They recognize that only the healthiest people tend to buy an immediate annuity, and they use assumptions for investment returns that are based on investment in fixed-income securities such as bonds and mortgages. Buying an annuity also means giving up flexibility, since the buyer transfers some or all of his money to an insurance company. That money can't be used to invest in equities, for major expenses, or for health-related expenses should the buyer's health suddenly deteriorate.

Annuities are a form of insurance, just like homeowners or life insurance. As such, they are intended to cover the financial loss of rare but costly occurrences, the way homeowners insurance insures against a house burning down or life insurance insures against a young, healthy person dying. Insurance is generally not intended to cover predictable, affordable expenses. Thus, high deductibles may make sense in some situations. After all, why pay an insurance company to cover costs that can be predicted and are affordable? Accordingly, knowing that most people live at least ten to fifteen years after retirement, retirees may find it desirable to manage their own money over those years, pay for expenses until age seventy themselves, and later use an annuity as insurance against living to a very old age. In fact, younger retirees may find that an annuity does not provide much more income than fixed-income securities like CDs or Treasury securities.

Another issue to consider is the complexity and effort of managing one's own money. Often, people find managing their investments easy at age sixty-five, but more than they can handle at eighty-five. An annuity lets an insurance company do this work.

The picture also changes as retirees get older and find that an annuity pays substantially more current income than other fixed-income investments. Research in this area, though not complete, supports the concept that an insured annuity is more useful at older ages. Waiting until age seventy or eighty to buy an annuity is often a good strategy, as older retirees may be more concerned about outliving assets and less concerned about future inflation. Also, buying an annuity by age seventy and one-half avoids any violation of IRS rules for minimum required distributions.

Choosing a strategy

Table 3 compares two strategies for retirement: keeping all of one's savings invested while taking money out systematically over a lifetime, or using part of savings to purchase an immediate annuity. A third strategy is to wait until at least age seventy to buy an annuity.

Make systematic withdrawals. This means spending money at a rate conservatively estimated to last the rest of one's life and investing the balance until it is needed. This strategy allows a person to tap into his or her savings to pay for expenses. One may decide to withdraw a set amount or percentage from retirement savings each year. This method provides freedom to invest one's money however one desires, as well as the flexibility to respond to needs or opportunities that may arise. For example, many of today's popular investment ideas, such as index funds, international funds, certificates of deposit, and money market funds, were unknown only a few decades ago, and other new concepts and products are likely to become available in the years ahead. A person can also easily change this strategy if purchasing an annuity begins to look attractive.

Using this approach, it is important not to withdraw too much money in any one year especially early in retirement. Too much money withdrawn at any one time will deplete one's retirement savings. It is also prudent to be conservative and update the plan every four years.

Use some assets to purchase an immediate income annuity. To eliminate some of the uncertainty, one can apply part of one's funds to buy an immediate income annuity, or use a company pension to supplement one's monthly income. An income annuity will convert part of retirement savings into a stream of monthly income that lasts for the rest of one's life. No matter how long a person lives, immediate income annuities can be another building block of income that can't be outlived, and they can be added to other sources of income that are typically considered the foundation of a retirement income, such as personal savings, Social Security, and pension proceeds.

Wait to buy an annuity until at least age seventy. Instead of purchasing an annuity from an insurer at the time of retirement, a person may want to manage his or her own money until a certain age, and then buy an annuity. This strategy preserves more flexibility to deal with changes that may occur, and it recognizes that an insured annuity provides more valuable longevity insurance at advanced ages. In other words, a person could choose to self-insure the longevity risk until age seventy or beyond, then buy an annuity if he or she remains in good health.

How much retirement income should come from an annuity?

This is also a question with no single answer. One should first establish a base level of retirement income according to one's present level of spending and lifestyle. Several approaches are possible:

  • No frills. The poverty level in 2000 was $8,350 for individuals and $11,250 for couples. If feasible, income should be at least 150 percent of the poverty level. In U.S. dollars in 2000, this would be $12,525 for individuals and $16,875 for couples.
  • Refocus. One should establish a budget that takes into account anticipated retirement expenses. For example, many retirees move to smaller, less expensive homes.
  • Aim high. Some people may be unwilling to retire with a reduced standard of living. It is a good idea to start with 70 percent of one's present income before taxes, and draw up a budget to pay for annual household expenses. Long-term costs like a new car and home maintenance need to be included.

It is also important to add up the guaranteed income that will be available to cover basic needs. Determine what income is expected from Social Security, which will cover part of one's base guaranteed income, then determine what income you can expect from pension plans. Annuity income from pension plans often is a better deal than an annuity bought in the open market. This is especially true for women because of unisex rates that pension plans must use.

If a pension and Social Security don't provide enough income, some people may wish to buy an annuity to get more guaranteed retirement income. If they do provide enough, it is a good idea to reevaluate at least every three years.

Retirement plans should take into account the possibility of the following major risks:

  • Inflation
  • Decline in value of savings and investments
  • Loss of ability to care for oneself or to make complex decisions
  • Being outlived by one's spouse or other dependents
  • Unexpected medical needs
  • Caring for parents or adult children

An annuity can pay for long-term care or life insurance, with annuity payments going directly to an insurance company to pay premiums for such coverage. However, premiums on long-term care policies are often not locked in permanently at one rate. They can be raised after a policy is purchased. Some insurers now offer a combined annuity and long-term care insurance policy. This can be a better deal than buying two products separately, but requires very careful shopping.

Tax considerations

It is important that individual taxpayers, especially those with high incomes, consult a qualified tax advisor for information on their own situations. However, some general guidelines include:

  • Annuity benefits are fully taxable if the annuity is purchased entirely with before-tax dollars, which are funds on which no tax has been paid, such as amounts held in tax deferred programs like IRAs or qualified pension plans.
  • If the annuity is purchased with after-tax dollars (funds on which all income taxes have been paid), benefits are tax-free until life expectancy has been reached (an age calculated on IRS actuarial tables). Once reaching that age, benefits are fully taxable.
  • Depending on the state, a person may pay little or no state income tax on retirement income. For retirees with high income, the state of residence can make a big difference.

How to shop for and purchase an annuity

A person should not put all his or her money into an annuity, because annuities don't allow withdrawals for unexpected expenses once the annuity income begins. Also, an annuity pays both principal and earnings, so while the annuitant gets a high guaranteed cash flow, heirs may receive considerably less.

An immediate annuity can be purchased with the funds available from a 401(k) plan, an individual retirement account (IRA), a savings account, a life insurance policy, an inheritance, or the money from selling a house. The following points should all be considered when shopping for an annuity.

Health status. One's health must be considered. After all, the reason to buy an annuity is the risk of outliving one's assets. For a person in good health, an annuity makes sense, but for someone in poor health, it's less likely to be a good buy unless an annuity with survivor benefits for the use of a spouse or heir is purchased. Some companies offer impaired life annuities to purchasers with medical conditions likely to shorten their lives, such as diabetes or heart disease.

Use a strong insurer. Check the financial rating of the insurance company to make certain that the company is going to be there for many years.

Find good rates. Compare rates among different insurers using a trusted insurance agent, accountant, actuary, tax professional, the Internet, or a personal contact. Comparing contracts for fixed annuities requires no physical work or paperwork. Comparing rates for variable annuities is a little more complex, and one should not be in a hurry to lock in interest rates. Money can be put in other investments until one is ready to buy an annuity.

Seek other help. A state insurance department won't recommend a company, but it can help if there are problems with a company or representative. Check to see how the annuity would be covered in the event that a company ever becomes unable to pay benefits. Some states won't guarantee any more than $100,000 worth of annuity value.

Anna M. Rappaport

See also Assets and Wealth; Bequests and Inheritances; Consumer Price Index and COLAs; Estate Planning; Life Expectancy; Pensions, Plan Types and Policy Approaches; Retirement Planning.


See Biomarkers of aging; life-span extension

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An annuity is an interest-bearing financial contract that combines the tax-deferred savings and investment properties of retirement accounts with the guaranteed-income aspects of insurance. Annuities can be described as the flip side of life insurance. Life insurance is designed to provide financial protection against dying too soon. Annuities provide a hedge against outliving your retirement savings. While life insurance plans are designed to create principal, an annuity is designed to liquidate principal that has been created, usually in the form of regular payments over a number of years.

Annuities can be purchased from insurance providers, banks, mutual fund companies, stockbrokers, and other financial institutions. They come in several different forms, including immediate and deferred annuities, and fixed and variable annuities. Each form has different properties and involves different costs. Although the money placed in an annuity is first subject to taxation at the same rate as ordinary income, it is then invested and allowed to grow tax-deferred until it is withdrawn. Distribution is flexible and can take the form of a lump sum, a systematic payout over a specified period, or a guaranteed income spread over the remainder of a person's life. In most cases annuities are a long-term investment vehicle, since the costs involved make it necessary to hold an annuity for a number of years in order to reap financial benefits. Because of their flexibility, annuities can be a good choice for small business owners in planning for their own retirement or in providing an extra reward or incentive for valued employees.


There are several different types of annuities available, each with different properties and costs that should be taken into consideration as business owners put together their retirement investment portfolio. The two basic forms that annuities take are immediate and deferred.

An immediate annuity, as the name suggests, begins providing payouts at once. Payouts may continue either for a specific period or for life, depending on the contract terms. Immediate annuitieswhich are generally purchased with a one-time deposit, with a minimum of around $10,000are not very common. They tend to appeal to people who wish to roll over a lump-sum amount from a pension or inheritance and begin drawing income from it. The immediate annuity would be preferable to a regular bank account because the principal grows more quickly through investment and because the amount and duration of payouts are guaranteed by contract. Immediate annuities are also known by the name income annuities. What is important to remember when considering an immediate annuity is that "at the end of the day, you've got to remember what you're buying is insurance, not an investment vehicle like a stock or mutual fund," explains Rob Nestor in an article by Murray Coleman in Investor's Business Daily.

Deferred annuities delay payouts until a specific future date. The principal amount is invested and allowed to grow tax-deferred over time. More common than immediate annuities, deferred annuities appeal to people who want a tax-deferred investment vehicle in order to save for retirement.

There are also two basic types of deferred annuity: fixed and variable. Fixed annuities provide a guaranteed interest rate over a certain period, usually between one and five years. In this way, fixed annuities are comparable to certificates of deposit (CDs) and bonds, with the main benefit that the sponsor guarantees the return of the principal. Fixed annuities generally offer a slightly higher interest rate than CDs and bonds, while the risk is also slightly higher. In addition, like other types of annuities, the principal is allowed to grow tax-deferred until it is withdrawn.

The more popular of the deferred annuity types is the variable annuity which offers an interest rate that changes based on the value of the underlying investment. Purchasers of variable annuities can usually choose from a range of stock, bond, and money market funds for investment purposes in order to diversify their portfolios and manage risk. Some of these funds are created and managed specifically for the annuity, while others are similar to those that may be purchased directly from mutual fund companies. The minimum investment usually ranges from $500 to $5,000, depending on the sponsor, and the investments (or subaccounts) usually feature varying levels of risk, from aggressive growth to conservative fixed income. In most cases, the annuity principal can be transferred from one investment to another without being subject to taxation. Variable annuities are subject to market fluctuations, however, and investors also must accept a slight risk of losing their principal if the sponsor company encounters financial difficulties.


Variable annuities have a number of features that differentiate them from common retirement accounts, such as 401(k)s and IRAs, and from common equity investments, such as mutual funds. One of the main points of differentiation involves tax deferral. Unlike 401(k)s or IRAs, variable annuities are funded with after-tax moneymeaning that contributions are subject to taxation at the same rate as ordinary income prior to being placed in the annuity. In contrast, individuals are allowed to make contributions to the other types of retirement accounts using pre-tax dollars. That is why financial specialists usually instruct people to first maximize their contributions to 401(k) plans and IRAs before considering annuities. On the plus side, there is no limit on the amount that an individual may contribute to a variable annuity, while contributions to the other types of accounts are limited by the federal government. Unlike the dividends and capital gains that accrue to mutual funds, however, which are taxable in the year they are received, the money invested in annuities is allowed to grow tax free until it is withdrawn.

Another feature that differentiates variable annuities from other types of financial products is the death benefit. Most annuity contracts include a clause guaranteeing that the investor's heirs will receive either the full amount of principal invested or the current market value of the contract, whichever is greater, in the event that the investor dies before receiving full distribution of the assets. However, any earnings are taxable for the heirs.

Another benefit of variable annuities is that they offer greater withdrawal flexibility than other retirement accounts. Investors are able to customize the distribution of their assets in a number of ways, ranging from a lump-sum payment to a guaranteed lifetime income. Some limitations, however, do apply. For example, the federal government imposes a 10 percent penalty on withdrawals taken by anyone before they reach the age of 59 1/2 years. But contributors to variable annuities are not required to begin taking distributions until age 85, whereas contributors to IRAs and 401(k)s are required to begin taking distributions by age 70 1/2.


In exchange for the various features offered by annuities, investors must pay a number of costs. Many of the costs are due to the insurance aspects of annuities, although they vary among different sponsors. One common type of cost associated with annuities is the insurance cost, which averages 1.25 percent and pays for the guaranteed death benefit in addition to the insurance agent's commission. There are also usually management fees, averaging 1 percent, which compensate the sponsor for taking care of the investments and generating reports. Many annuities also charge modest administrative or contract fees.

One of the more problematic costs of annuities, in the eyes of their critics, is the surrender charge for early removal of the principal. In most cases, this fee begins at around 7 percent but then phases out over time. However, the surrender fee is charged in addition to the 10 percent government penalty for early withdrawal if the investor is under age 59 1/2.

All of the costs associated with variable annuities detract somewhat from their attractiveness as a financial product when one compares them to mutual funds. The costs also mean that there are no quick profits associated with annuities; instead, they must be held as a long-term investment. In fact, it can take as long as 17 years for the benefits of tax deferral to outpace the administrative expenses of an annuity. For investors who wish to put money away for an extended period, a variable annuity may be a very good investment vehicle.


On the positive side, investors in annuities have a number of options for receiving the distribution of their funds. The three most common forms of distributionall of which have various costs deductedare lump sum, lifetime income, and systematic payout. Some investors who have contributed to a variable annuity over many years may elect to take a lump-sum withdrawal. The main drawback to this approach is that all the taxes are due immediately. Other investors may decide upon a systematic payout of the accumulated assets over a specified time period. In this approach, the investor can determine the amount of payments as well as the intervals at which payments will be received. Finally, some investors choose the option of receiving a guaranteed lifetime income. This option is the most expensive for the investor, and does not provide any money for heirs, but the sponsor of the annuity must continue to make payouts even if the investor outlives his or her assets. A similar distribution arrangement is joint-and-last-survivor, which is an annuity that keeps providing income as long as one person in a couple is alive.

Annuities are rather complex financial products, and as such they have become the subject of considerable debate among experts in financial planning. As mentioned earlier, many experts claim that the special features of annuities are not great enough to make up for their cost as compared to other investment options. As a result, financial advisors commonly suggest that individuals maximize their contributions to IRAs, 401(k)s, or other pre-tax retirement accounts before considering annuities (investors should avoid placing annuities into IRAs or other tax-sheltered accounts because the tax shelter then becomes redundant and the investor pays large annuity fees for nothing). Some experts also prefer mutual funds tied to a stock market index to annuities, because such funds typically cost less and often provide a more favorable tax situation. Contributions to annuities are taxed at the same rate as ordinary income, for instance, while long-term capital gains from stock investments are taxed at a special, lower rateusually 20 percent. Still other financial advisors note that, given the costs involved, annuities require a very long-term financial commitment in order to provide benefits. It may not be possible for some individuals to tie up funds for the 17 to 20 years it takes to benefit from the purchase of an annuity.

Despite the drawbacks, however, annuities can be beneficial for individuals in a number of different situations. For example, annuities provide an extra source of income and an added margin of safety for individuals who have contributed the limit allowed under other retirement savings options. In addition, some kinds of annuities can be valuable for individuals who want to protect their assets from creditors in the event of bankruptcy. An annuity can provide a good shelter for a retirement nest egg for someone in a risky profession, such as medicine. Annuities are also recommended for people who plan to spend the principal during their lifetime rather than leaving it for their heirs. Finally, annuities may be more beneficial for individuals who expect that their tax bracket will be 28 percent or lower at the time they begin making withdrawals.

Annuities may also hold a great deal of appeal for small businesses. For example, annuities can be used as a retirement savings plan on top of a 401(k). They can be structured in various ways to reward employees for meeting company goals. In addition, annuities can provide a nice counterpart to life insurance, since the longer the investor lives, the better an annuity will turn out to be as an investment. Finally, some annuities allow investors to take out loans against the principal without paying penalties for early withdrawal. Overall, some financial experts claim that annuities are actually worth more than comparable investments because of such features as the death benefit, guaranteed lifetime income, and investment services.

A small business owner considering setting up an annuity should consider all options, look carefully at both the costs and the returns, and be prepared to put money away for many years. It is also important to shop around for the best possible product and sponsor before committing funds. "Before investing in an annuity, make sure the insurance company that will sponsor the contract is financially healthy," counseled Mel Poteshman in Los Angeles Business Journal. "Also, find out from the sponsoring company the interest rates that have been paid out over the last five to ten years and how interest rate changes are calculated. This will give you an idea of the annuity's overall performance and help you identify the annuity that provides the best long-range financial security.

see also Retirement Planning; Life Insurance


Baldwin, Ben The New Life Insurance Investment Advisor. Second Edition. McGraw-Hill, 2001.

Chandler, Darlene K. The Annuity Handbook: A Guide to Nonqualified Annuities. Third Edition. National Underwriter Company, 2002.

Clements, Jonathan. "Ensuring Your Nest Egg Doesn't Crack." Wall Street Journal. 8 February 2000.

Coleman, Murray. "Immediate Annuities: Wave of Future?" Investor's Business Daily. 8 November 2004.

                              Hillstrom, Northern Lights

                               updated by Magee, ECDI

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