Annuities Explained: Types, Costs, and When They Make Sense

Most deferred annuities carry a surrender charge schedule — a fee you pay if you withdraw more than the free withdrawal allowance (typically 10% of contract value per year) during the surrender period.

Surrender periods commonly run 7–10 years.

Charges often start at 7–10% in year one and decline by roughly one percentage point per year until they reach zero.

For example, a contract with a 7-year surrender schedule might charge 7% in year one, 6% in year two, and so on, with no charge from year eight onward. Large early withdrawals from annuities can result in substantial surrender charges in addition to tax consequences.

A fixed annuity credits a fixed interest rate for a specified period — similar conceptually to a bank certificate of deposit, but issued by an insurance company.

The rate is set by the insurer and may be renewed at a different rate at the end of the initial term.

Fixed annuities are the simplest and typically least expensive type.

They are not securities and are regulated only at the state insurance level. They are not FDIC insured — your protection comes from the insurance company's claims-paying ability and, in some cases, your state's insurance guaranty association (which has per-contract limits that vary by state).

A variable annuity allows you to allocate your premium among investment subaccounts that function similarly to mutual funds (stock, bond, balanced, or money market subaccounts).

Your contract value rises and falls with the performance of the subaccounts you choose.

Variable annuities offer higher growth potential than fixed annuities but also carry investment risk — your contract value can decrease.

Variable annuities are regulated as securities by the SEC and FINRA, and sales representatives must hold an insurance license as well as a securities license (Series 6 or 7).

According to FINRA's investor guidance on variable annuities, these products carry higher fees than most other investment options, and investors should carefully evaluate whether the benefits justify the costs before purchasing.

A fixed-indexed annuity credits interest based on the performance of an external market index — commonly the S&P 500 — subject to a cap rate (maximum gain credited per period) and a floor (minimum gain, often 0%, meaning you cannot lose principal due to index performance).

FIAs offer a middle ground: more growth potential than traditional fixed annuities during strong market years, with principal protection during down markets.

FIAs are insurance products (not securities) and are regulated at the state level. The cap rates and participation rates — which determine how much of the index's gain is credited to your account — are set by the insurer and may change at renewal.

A single premium immediate annuity (SPIA) converts a lump sum into income payments that begin within one month to one year of purchase.

SPIAs are commonly used by retirees who want to convert a portion of their savings into a predictable, contractual income stream they cannot outlive.

Once payments begin, however, the contract is generally irrevocable — you cannot access the principal in a lump sum again.

Variable annuities in particular often carry multiple layers of fees.

The mortality and expense (M&E) risk charge, administrative fees, and optional rider fees (for income guarantees, enhanced death benefits, or long-term care riders) may collectively reach 1–3% of contract value per year.

Over a 20-year period, these fees may substantially reduce the final account value compared to a comparable low-cost investment portfolio.

Surrender charges during the initial period — often 7–10 years — mean that annuities are illiquid relative to mutual funds or ETFs.

If you need access to your money before the surrender period ends, you may owe significant fees.

Most contracts allow a 10% free withdrawal annually, but amounts above that trigger the surrender charge.

Annuity contracts are obligations of the issuing insurance company, not a bank.

They are not FDIC insured.

If the insurer becomes insolvent, policyholders may turn to the state insurance guaranty association for protection — but guaranty association limits vary by state and may not cover the full contract value.

Selecting an insurer with strong financial strength ratings (from agencies such as AM Best or Moody's) may reduce this risk.

Unlike long-term capital gains or qualified dividends, all earnings withdrawn from a non-qualified annuity are taxed as ordinary income.

This may be disadvantageous for investors in higher tax brackets compared to holding the same investments in a taxable brokerage account, where growth would be subject to potentially lower long-term capital gains rates. Mutual funds held in a taxable account, for instance, may qualify for lower capital gains rates on their distributions.