Annuities: When They Actually Make Sense (and When They Don't)

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At age 65, a $200,000 single premium immediate annuity buys roughly $1,200 a month for life from a top-rated insurer. That is a 7.2% annual payout rate, higher than the 4% rule allows on a portfolio of the same size. The catch: when you die, the payments stop. That is not a defect. It is the product. SPIAs are pure longevity insurance, and for retirees worried about outliving their money, they are often the right answer. Almost every other annuity sold today is something different — usually something worse.

Key takeaways

• Single premium immediate annuities (SPIAs) are genuine longevity insurance and often a smart layer of retirement income.
• Deferred variable annuities, indexed annuities, and most fixed deferred annuities are rarely worth their fees and surrender charges.
• A $200k SPIA at age 65 pays roughly $1,200/month for life, beating the 4% rule if you live past your life expectancy.
• The exclusion ratio reduces taxable income on SPIA payments by treating part of each payment as return of principal.
• Annuity commissions are highest on the worst products. If an agent leads with indexed or variable, walk.

The four products called "annuities"

The word covers very different products. Treat each separately.

1. Single premium immediate annuity (SPIA)

You hand the insurer a lump sum. Starting immediately, they pay you a fixed monthly amount for life (or for a chosen term). No cash value, no surrender option, no investment choices. The simplest possible product. This is the one most worth your attention.

2. Deferred fixed annuity (MYGA)

You hand the insurer a lump sum. They credit a fixed interest rate for a set term (3, 5, 7, 10 years). At the end, you can withdraw, roll over, or annuitize. Essentially a CD with tax deferral and surrender charges. Sometimes competitive when MYGA rates exceed CD rates by more than 50 basis points.

3. Indexed annuity

You hand the insurer a lump sum. They credit interest based on a stock index, with caps, floors, and participation rates that they can adjust. Sold as "stock market upside with no downside." In practice, internal costs run 1.5-3% a year and caps often make realized returns lower than a bond fund.

4. Deferred variable annuity

You hand the insurer a lump sum. It is invested in subaccounts (essentially mutual funds) with insurance wrappers. Total annual costs frequently exceed 3% a year. Most include guaranteed living benefit riders that sound valuable and almost never pay off.

The SPIA math at 65

Rates assume top-rated carriers, life-only payout, no period certain. Joint life pays less because the insurer is on the hook for two lives. Quotes change with interest rates; current quotes are the highest they have been in 15 years.

SPIA vs the 4% rule

The 4% rule says you can withdraw 4% of your starting portfolio (adjusted for inflation) each year and have a high probability of not running out over 30 years. On $200,000, that is $8,000 a year, or about $667 a month.

A SPIA on the same $200,000 pays roughly $1,250 a month — almost double. The catch: the payments are not inflation-adjusted unless you buy an inflation rider (which reduces the starting payment by 25-35%), and the residual value at death is zero.

This trade-off is the entire point. With a portfolio, you keep optionality and leave a legacy, but you carry the longevity risk. With a SPIA, the insurer carries the longevity risk, and you trade the legacy for higher current income.

When a SPIA is the right answer

• You are 65 or older and worried about outliving your money.
• You have no pension and want a steady income floor in addition to Social Security.
• You are in good health and have a family history of longevity.
• You can cover your essential expenses (housing, food, healthcare) with Social Security + SPIA income, leaving your portfolio for discretionary spending.
• You don't have a strong legacy motive for the SPIA portion.

When a SPIA is the wrong answer

• You are under 60. Annuitizing too early forfeits the mortality credits that make SPIAs work.
• You are in poor health. The insurer pools risk across all healthy buyers; if your life expectancy is below average, you are buying at a bad price.
• You already have a pension that covers essentials. You don't need to buy more annuity income.
• You have strong legacy goals for the principal.
• You can cover essentials with Social Security alone and want to keep portfolio optionality.

The exclusion ratio

SPIA payments from non-qualified money (after-tax dollars, not from an IRA) are part return of principal and part interest. The IRS uses an exclusion ratio to determine how much of each payment is taxable.

Example: a 65-year-old man buys a $200,000 SPIA paying $1,250/month for life. The IRS expected return tables give him a life expectancy of about 20 years, so total expected payments are $300,000. Of each $1,250 monthly payment, $833 (200,000 / 300,000 × 1,250) is non-taxable return of principal. Only $417 is taxable interest. Once you have lived past life expectancy and recovered all your principal, the entire payment becomes taxable.

SPIAs from qualified money (IRA, 401(k)) are fully taxable. There is no exclusion ratio because none of the dollars were after-tax to begin with.

The case against deferred variable annuities

The pitch: tax-deferred growth, guaranteed minimum income benefit, market upside, principal protection. The reality:

• Total internal costs of 2.5-3.5% a year (mortality and expense charges, subaccount fees, rider fees).
• Surrender charges of 5-10% for the first 7-10 years.
• Guaranteed income riders often pay out at less than current SPIA rates — you would do better waiting and buying a SPIA.
• Tax deferral is identical to what an IRA or 401(k) gives you for free.
• Gains come out as ordinary income, not long-term capital gains.

The product was designed for the agent's commission, which typically runs 5-7% of premium. A $200,000 variable annuity sale puts $10,000-$14,000 in the agent's pocket on day one.

The case against indexed annuities

Marketed as "the upside of stocks with the safety of CDs." The mechanics:

• You get a percentage of an index's gain, subject to a cap (e.g., 8% a year max).
• The cap can be reset downward each year at the insurer's discretion.
• You typically do not receive dividends, which are 30-40% of historical S&P returns.
• Surrender charges of 10-14 years are common.
• Commissions run 6-9% of premium.

Academic research from Wharton and elsewhere has consistently found indexed annuity realized returns averaging 2-4% a year — below long-term bond yields. They are sold, not bought.

When a MYGA might fit

Multi-year guaranteed annuities are the only deferred annuity worth a serious look. They are essentially tax-deferred CDs. Right now, top-rated 5-year MYGAs are paying 5.0-5.5%. If you are in a high tax bracket and want to defer interest income, and you have used up your IRA and HSA space, a MYGA can beat a taxable CD on after-tax return. Read the surrender schedule carefully and never invest money you might need before the term ends.

If you want to compare current MYGA and SPIA rates without a sales pitch, independent quote aggregators let you see live numbers across A-rated carriers.

The longevity math

The reason SPIAs work is mortality credits. Some buyers will die early, and the insurer keeps their unused premiums. Those credits get redistributed to the buyers who live long. The longer you live, the better deal you got.

The SPIA is a hedge against living too long, not an investment. If you are confident you will die at average life expectancy, a portfolio drawdown almost certainly beats it. If you are healthy at 65 with parents who lived into their 90s, the SPIA gets very attractive.

How to buy a SPIA correctly

1. Wait until 65 or later. The math is much better at older ages.
2. Compare 3-5 carriers. Quotes vary by 5-15% for identical income on the same day.
3. Use only A or A+ rated carriers (AM Best). State guarantee associations are limited.
4. Annuitize only a portion — 25-40% of your portfolio is a common rule. Keep the rest invested for growth, inflation protection, and legacy.
5. Consider laddering. Buy a SPIA at 65, another at 70, another at 75. Lifetime payouts get more generous at older ages and you stagger interest rate exposure.
6. Skip riders unless one specifically solves a planning problem. Period-certain, cash refund, and inflation riders all reduce the base payment.

Related reading

• Social Security at 62 vs 67 vs 70: The Break-Even Math — Claim at 62 and you lock in roughly 70 percent of your full benefit for life. Wait until 70 and you collect 124 percent. The decis…
• The 4% Rule Explained: How Much You Really Need to Retire — Multiply your portfolio by 4% and you have a number most retirees can spend each year for 30 years without running out. That singl…
• Roth Conversion Ladder: How Early Retirees Tap 401(k) Money — Early retirees face a 10% penalty on Traditional 401(k) withdrawals before age 59.5. The Roth conversion ladder is the FIRE commun…
• Term vs Whole Life Insurance: Why Permanent Is Usually Wrong — Whole life is sold hard because it pays the agent a commission roughly equal to the first-year premium. Term is sold soft because…

FAQ

What is the difference between an immediate and deferred annuity?

An immediate annuity (SPIA) begins payments within 12 months of purchase. A deferred annuity accumulates value for years before payments start (if they ever start — many are surrendered for cash instead).

Are annuities a good idea for retirement income?

SPIAs can be an excellent piece of a retirement income plan, used to cover essential expenses alongside Social Security. Other annuity types are rarely the best tool.

What happens to my SPIA money when I die?

With a life-only SPIA, payments stop at your death and the insurer keeps any remaining premium. With a period-certain or cash-refund rider, payments continue to a beneficiary, but base payments are lower.

Are SPIA payments inflation-adjusted?

Not unless you buy an inflation rider, which reduces the starting payment by 25-35%. Most retirees instead hold a smaller SPIA position alongside stocks for inflation protection.

How safe is an annuity if the insurer fails?

State guarantee associations cover annuity contracts, with limits that vary by state (commonly $100k-$250k of present value). Stick to A or A+ rated insurers and stay within state limits.

Can I cancel an annuity after I buy it?

SPIAs are generally irrevocable after the free-look period (10-30 days depending on state). Deferred annuities can be surrendered, usually with surrender charges of 5-10% in the early years.

Is a 401(k) annuity option worth using?

The SECURE Act made it easier for 401(k) plans to offer annuities. Compare any in-plan annuity offer to the open market — captive offerings often pay less.

Should I roll my 401(k) into an annuity?

Maybe a portion. Annuitizing your entire retirement balance is almost always wrong. Annuitizing 20-30% to create a guaranteed income floor can be sensible.

Are indexed annuities ever a good idea?

Rarely. The combination of caps, participation rates, missing dividends, and surrender schedules makes them inferior to a simple stock/bond portfolio for nearly all buyers.

How are annuity payments taxed?

SPIA payments from after-tax money use the exclusion ratio (partly tax-free return of principal). SPIA payments from qualified money (IRA, 401(k)) are fully taxable as ordinary income. Gains from deferred annuities come out as ordinary income, never long-term capital gains.

Bottom line

SPIAs are a real, useful piece of retirement plumbing. Used to cover essential expenses for a long-lived retiree without a pension, they shift longevity risk off your balance sheet and onto the insurer's. Almost every other annuity sold today — variable, indexed, deferred fixed beyond a simple MYGA — has fees and complexity that benefit the seller more than the buyer. The simplest rule: if an annuity has a surrender period longer than five years, a commission paid to an agent, and a marketing pitch that emphasizes "market upside," you can almost certainly do better with a low-cost portfolio plus a properly sized SPIA at age 70 or 75.