The Annuity Question I Keep Hearing (And What You Should Know Before Signing)

Note: The examples and case studies in this article are hypothetical but represent real situations I have encountered in my practice working with Washington State public employees.

I was sitting in a meeting with a client last month when she pulled out a colorful brochure.

"My brother-in-law says I need one of these," she said. "For guaranteed income."

It was an annuity proposal. Variable annuity with riders and guarantees. Promises that her retirement would be "protected."

She'd been planning to retire at 62 with about $750,000 saved. Now she was second-guessing everything.

I looked at the proposal. Then I looked at her situation.

The Fear That's Real

Here's what I see happening.

People are living longer. A 65-year-old today has an average life expectancy of 84, according to Social Security.¹ But that's just average. If you're healthy with longevity in your family, you might need to plan for 30 years in retirement.

That's a long time to make money last.

And inflation doesn't take a break. Since 1925, it's averaged about 3% per year.² At that rate, someone who needs $50,000 today would need nearly $120,000 in 30 years just to buy the same stuff.

So the fear is real. Running out of money. Watching your purchasing power shrink. Market crashes at exactly the wrong time.

Annuity salespeople know this. They know exactly which buttons to push.

And the promise of guaranteed lifetime income? It sounds perfect.

But here's what I want to walk you through. How these guarantees actually work. What they cost. And what you're giving up.

Two Types You'll Hear About

At the basic level, there are two kinds.

Deferred annuities are like a traditional IRA wrapped in an insurance product. You put money in. It grows tax-deferred. Later, you convert it to income payments.

Immediate annuities work differently. You hand the insurance company a lump sum (say $100,000). They immediately start sending you monthly checks. For a set number of years, or for life.

Annuities purchased through the Washington State Department of Retirement Systems are immediate annuities.

But here's the thing. When you buy one, you're handing over control. That money's gone. You can't change your mind. You can't leave it to your kids if you die early.

Instead of keeping the money invested and managing it yourself, you're betting the insurance company's guarantee is worth more than the flexibility.

What Is a Variable Annuity?Most of what I'm seeing pitched are variable annuities.

Think of it like this: mutual funds + tax deferral + insurance contract.

The mutual funds look like what you'd see in your 457(b) or 401(k). Stock funds, bond funds. Your account goes up and down based on what those funds do.

The insurance contract is where it gets complicated.

But first, here's something critical.

If you're funding a variable annuity with IRA money or DCP money, you're putting tax-deferred dollars into a tax-deferred product.

You already have the tax benefit. You're paying extra fees for something you don't need.³

There are cases where someone really wants the insurance features. Income guarantees. Death benefits. That might justify it.

But you need to know you're paying for those features on top of the tax deferral you already had.

The Guarantee That Isn't What It Sounds Like

Here's where people get tripped up.

Variable annuities have guarantees. The salesperson will tell you things like "your account is guaranteed to grow 7% per year no matter what" or "once your account hits a new high, that's locked in forever."

Those statements aren't lies.

But they don't mean what you think they mean.

The guarantees apply to something called the "income benefit base." It's an accounting number. A calculation the insurance company uses to figure out how much income they'll pay you later.

It's not actual money you can touch.

Your real account value (the money you'd get if you cashed out) still goes up and down with the market.

Let me show you what this looks like.

You invest $100,000. The market drops. Your investments are now worth $80,000. You decide you want out.

You get $80,000 minus surrender charges. If you're in year one with a 7% surrender charge, that's another $5,600 gone. You walk away with $74,400.

The "guaranteed 7% growth" doesn't protect you from that.

The actual insurance kicks in later. If you keep the contract and start taking income, and poor markets eventually drive your account to zero, the insurance company keeps paying you.

That's real. That's the benefit.

But it's not a guarantee on money you can access today. It's a promise about income payments maybe 10 or 15 years from now.

When you're deciding if this is worth it, ask this: If I cancel this contract in one year, three years, five years, how much do I actually get back after fees and taxes?

What You're Really Paying For

Variable annuities are insurance. Insurance costs money.

Every guarantee you see costs something. Downside protection. Inflation riders. Income for life. Nobody's giving that away.

Here is an example of how the fees are stacked on top of each other:

Mortality and expense: 1.00% to 1.50% per year. Admin fees: 0.10% to 0.20%. Annual contract fee: $25 to $50. Mutual fund expenses inside: 0.50% to 1.50%. Surrender charges if you leave early. Rider fees: another 0.40% to 1.50% each.

According to FINRA's analysis of over 48,000 annuity policies, total fees can hit 3.88% per year.⁴

Let me put that in real numbers. I met with someone recently who had $1 million in a variable annuity. The fees were running about 3% per year. That's $30,000 annually.

The Lock-In You Don't See Coming

Even when someone realizes the annuity doesn't fit, getting out isn't simple.

Enter: Surrender charges.

Typical schedule: 7% of your premium in year one, declining 1% each year over seven to ten years.

On $1 million, a 7% surrender charge is $70,000. Just to access your own money.

In year four? Still $40,000 (assuming it drops to 4%).

These aren't just fees. They lock you into the contract's original assumptions. The income structure. The investment options. Everything.

Then the surrender period stretches across years when things change. The economy improves. Your health changes. Tax laws change. Your goals shift.

But you're stuck. The contract doesn't change. And the cost to leave is too high.

Inflation Eats Fixed Payments

Variable annuities are invested in stocks and bonds. But the income guarantees? Usually fixed in nominal dollars.

If you fall back on the guarantee, you're locked into a flat payment. Inflation slowly destroys it.

Let's say you start taking $30,000 per year. In ten years, you're still getting $30,000. But at 3% inflation, you'd need $40,300 to buy the same stuff.

The annuity company will sell you an inflation rider. But it costs extra.

So you choose: locked-in payments that lose value every year, or higher fees.

Not great options.

Trading Growth for the Illusion of Safety

Here's the biggest issue.

You're trading decades of growth for short-term comfort.

Fixed indexed annuities are the perfect example.

They sound great. Principal "protected" from losses. You "participate" in market gains.

But when the market goes up 15%, you might get 7% to 10%. Because of caps. Spreads. Participation limits.⁵

So yes, when the market drops 30%, you don't lose anything that year. Feels good.

But since 1928? S&P 500 returns are positive about 67% of the time. And since 1970 they are positive about 75% of the time (custom analysis with data from Macro Trends).

Every one of those positive years, you're getting a fraction of the actual return.

But to clarify, as long as you can avoid selling investments at a loss, you’re not actually losing money. So over a long enough period of time the “protection” you are buying from the insurance company is very likely not necessary.

That's not protection. That's opportunity cost dressed up as safety.

What To Do Instead

So if these have high fees, kill flexibility, create inflation risk, and trade away growth, what's the alternative?

Build your own.

A globally diversified portfolio of stocks and bonds. A flexible withdrawal strategy. Cash and bonds for volatility protection.

Here's how it works.

Keep roughly five years of withdrawals in high-quality, short-term bonds and cash. Not junk bonds.

If you need $50,000 per year from your portfolio, maintain about $250,000 in that stability bucket. The rest stays in stocks for growth.

When markets drop 20% or 30%, you're not selling stocks. You're pulling from bonds and cash. The stocks recover. You're not paying 3% or 4% in fees for this.

You're just diversified properly.

And if you hire an advisor to help, you're still paying a fraction of what annuities cost. Plus you get actual planning. Tax strategy. Estate planning. Real advice.

The Tax Trap

Here's what nobody talks about.

Variable annuities destroy your tax flexibility.

When you take money out, all the growth is taxed as ordinary income. Not capital gains rates. Not qualified dividend rates. Ordinary income.³

For most people, that's the highest rate they'll pay. Could be 22%. Could be 24%. Could be 32% or higher.

Compare that to a regular brokerage account.

Long-term capital gains? 0% to 20% depending on income. Most retirees pay 15%. Qualified dividends get the same treatment.

You control what you sell. When you sell it. You can harvest losses to offset gains. Manage your tax bill year by year.

With an annuity? Once money goes in, every dollar of growth comes out as ordinary income.

And if you're under 59½, the IRS adds a 10% penalty.

If you funded it with IRA money, it's even simpler. Every dollar out is ordinary income. The annuity didn't improve your taxes at all. You just added expensive insurance features to dollars that were already going to be fully taxed.

Questions to Ask

If someone's pitching you an annuity, here's what you need clear answers to:

What type is it? Variable? Fixed? Indexed? Immediate?

What does it cost each year? Every fee. All of them.

What are the surrender charges? Exact schedule.

Are there caps on returns? Participation rates? What growth am I giving up?

Is income adjusted for inflation? How much does that cost?

How is guaranteed income calculated? Actual account value or internal benefit base?

What planning services am I getting? Or just insurance?

How does this affect my tax flexibility?

If you can't get specific answers, don't sign.

What That Client Decided

We walked through all of this.

The fees. The opportunity cost. The flexibility she'd lose. The surrender charges. The inflation problem.

She didn't need more guaranteed income at the cost of fees, growth, and flexibility.

She needed a comprehensive plan. One that coordinated her accounts, Social Security timing, taxes. One that gave her confidence without locking everything away.

No annuity. No surrender charges. No 3.5% annual fees. No locked-in payments losing value to inflation. No sacrificed growth. No destroyed tax flexibility.

Just a clear plan. Confidence without giving up control.

She still has that brochure somewhere. But she's not using it - well maybe as a coaster for her morning coffee.

Sources
1. Social Security Administration. "Period Life Table." ​https://www.ssa.gov/oact/STATS/table4c6.html​
2. Bureau of Labor Statistics. "Consumer Price Index." ​https://www.bls.gov/cpi/​
3. Internal Revenue Service. "Annuities - A Brief Description." https://www.irs.gov/retirement-plans/annuities-a-brief-description
4. Financial Industry Regulatory Authority. "Variable Annuities: What You Should Know." ​https://www.finra.org/rules-guidance/key-topics/variable-annuities​
5. Fidelity Investments. "What is a fixed indexed annuity?" ​https://www.fidelity.com/learning-center/personal-finance/retirement/fixed-indexed-annuity​
6. Guyton, Jonathan T., and William J. Klinger. "Decision Rules and Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe?" Journal of Financial Planning, October 2006.

-Seth Deal