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Does an Annuity Make More Money Than Direct Investing?

An annuity is a contract that pays a stream of cash flow for a fixed period of time or for life in exchange for an initial investment (premiums). 

Immediate annuities are funded through an up-front lump-sum payment, with payouts starting immediately. Deferred annuities can be funded over an extended accumulation period and have two phases: (1) the accumulation phase, during which you pay premiums and earnings grow tax-deferred, and (2) the income or annuitization phase, when you receive payments. 

What Is the Difference Between a Fixed Annuity and a Variable Annuity?

Fixed annuities provide you a guaranteed minimum-interest income. The insurance company assumes the market risk of investing your premiums.  With a variable annuity, you direct how your premiums are invested, and you retain the market risk of investing. Contrary to the fixed annuity where—barring a credit event at the insurer—you’ll receive your promised income stream, with a variable annuity your income stream is contingent on market fluctuations.

Are Annuities Good Investments?

Increasing life-expectancies, the disappearance of defined-benefit pension plans and concerns about Social Security have increased public demand for annuity products. Annuities offer several attractions:

  1. tax-deferred earnings;
  2. both death-benefit and living-benefit options;
  3. some protection from outliving your savings. (For related reading, see: Who Benefits From Retirement Annuities.)

Annuities can have a place in an investment portfolio, but before committing to them you should consider the following:

  • Insurance contracts are risk management tools. They are not a replacement for a sound, long-term horizon investment portfolio. Insurance companies cannot “manufacture” returns, and they face the same set of investment choices and challenges that you do.  Added guarantees that are offered with annuity contracts cost money and increase your premiums. 
  • Annuity earnings are taxed as ordinary income (rather than capital gains) when they are distributed. Gains from the tax-deferral on earnings may not fully compensate for the difference between your income tax and long-term capital gains tax rates. Also, remember that a low-turnover investment portfolio also provides tax deferral by holding good investments for a long period of time. (For related reading, see: Maximize the Tax Benefit From Your Annuity.)
  • Holding annuities in a qualified retirement plan is somewhat redundant since qualified plans already deliver the tax-deferral benefit.
  • Annuities invested in equities are poor inheritance-transfer vehicles. Upon death, beneficiaries don’t get a step-up in the basis on those stocks.
  • Annuities have a high expense structure, which can be 3-5% or more of your investment. 


Should I Pay for Annuity Riders or Guarantees?

Variable annuities carry market risk and the potential loss of principal, so insurers offer protective riders for extra cost. Evaluating riders is difficult, and requires modeling different scenarios over time. A percentage point in expense can cause a significant difference in financial outcomes over time. (For related reading, see: Living and Death Benefit Riders: How Do They Work?)

Should I Invest Directly or Buy an Annuity?

This is the key question, and the answer is, “it depends.”  Questions involving long-term time horizons and multiple variables can only be answered by modeling the different options. The following example is based on a real case. 

Mr. Smith, age 60, had invested $150,000 in a variable annuity in 2007. Its current value was $168,000 and his expenses and fees had been averaging 4.4%. Mr. Smith wanted to know if he should keep the annuity or cancel it and invest the funds directly, incurring a 1% management fee. The projected annualized returns for equities was 5%.  

We calculated the net present value of the annuity’s future distributions, along with values when investing directly. The tables below show the modeling results, based on client lifespans and various discount rates.



For Mr. Smith, investing directly produced superior results, unless he expected to live to age 95 or beyond. This does not mean direct investment is always superior. Each investor’s situation is unique, as is each annuity contract. Instead, this case highlights the complexity of such a decision, and the value of modeling the potential results.

(For more from this author, see: Why Investors Should Use Duration to Compare Bonds.)


This article might contain forward-looking statements, which involve risks and uncertainties. Actual results may differ significantly from the results described in the forward-looking statements. The information contained herein is from sources, which are believed to be reliable, but FPCM does not offer any guarantees as to its accuracy or completeness. Nor are they intended as a forecast or guarantee of future results. The information is not necessarily updated on a regular basis; when it is, the date of the change(s) will be noted. In addition, opinions and estimates are subject to change without notice. Reproduction without written permission is prohibited.