An annuity is a contract with an insurance company that provides income, usually during retirement.
People often look at annuities when they want more predictable income and less worry about running out of money. Like most retirement tools, annuities have benefits and trade-offs, which is why understanding how they work is important.
The basic idea of an annuity
When you buy an annuity, you give money to an insurance company. In return, the insurance company agrees to pay you income based on the terms of the contract.
That income can start right away or at a later date. In many cases, the income can last for a specific number of years or for the rest of your life.
Annuities are mainly used for retirement income, not short-term savings.
The two phases of an annuity
Most annuities have two main phases.
The accumulation phase
This is the period when money is added to the annuity. The funds may grow based on interest, a fixed rate, or market performance, depending on the type of annuity.
The payout phase
This is when the annuity starts paying income. Payments may be monthly, quarterly, or annual, depending on the contract.
Not all annuities have long accumulation phases. Some are designed to start income almost immediately.
Immediate vs. deferred annuities
There are two common timing options for annuities.
Immediate annuities
Income starts soon after the annuity is purchased, often within a year. These are usually used by people who are already retired or close to retirement.
Deferred annuities
Income starts later, after a waiting period. These are often used by people planning ahead for future income needs.
Both types are focused on income, but they serve different timing goals.
Guaranteed income and annuities
One of the main reasons people consider annuities is the guaranteed income they provide.
Many annuities can provide income that is not tied to the stock market. Some are designed to pay income for life, which can help reduce the risk of outliving savings.
Because of this, annuities are sometimes compared to pensions and Social Security. All three can provide a steady income over time.
Trade-offs to understand
Annuities also have downsides.
Once money is placed into an annuity, access to that money is often limited. Some annuities charge penalties for early withdrawals. Others may lock money up for many years.
Annuities can also be complex. Terms, fees, and payout options vary widely between contracts.
This is why annuities are not right for everyone and are usually just one part of a larger retirement income plan.
How annuities fit into a retirement income strategy
Annuities are typically used to increase guaranteed income, not to replace all savings.
Some retirees use annuities to help cover basic expenses. Others choose not to use them at all and rely on different income sources.
To understand how annuities fit alongside other income options, such as Social Security, retirement accounts, and personal savings, see our Retirement Income Strategies Overview, which explains how retirees often combine multiple income sources.