What an annuity actually guarantees, and what it does not

I have spent much of the past twenty years training insurance agents. That gives me a particular view of annuities, which is that they are genuinely useful for one narrow job and are routinely sold as though they were useful for everything.

So here is the honest version of what the word "guaranteed" is doing when it appears in an annuity illustration.

Where the guarantee actually comes from

An annuity is a contract with an insurance company. The guarantee is that company's contractual promise, and it is backed by that company's ability to pay its claims. It is not a bank deposit. It is not insured by the FDIC. There is no federal agency standing behind it.

Which means the financial strength of the company issuing the contract is not a detail. It is the guarantee. An illustration from a weak carrier showing a better number than a strong carrier is not a better deal, and if anyone ever shows you two illustrations side by side without discussing who is behind them, that tells you something about the person showing you.

The two numbers people confuse

This is the single most common misunderstanding I encounter, and it causes real anger when people discover it late.

Many income-focused annuities track two separate values. There is the account value, which is your actual money, the amount you could walk away with. And there is a separate benefit base, sometimes called an income base or a rollup value, which exists only to calculate your future income payments.

The benefit base often grows at an attractive stated rate. That number is usually the one printed largest. But you generally cannot withdraw the benefit base. It is not a pile of money with your name on it. It is a figure used in a formula that determines your monthly income, and if you surrender the contract you receive the account value, which may be considerably lower.

If someone shows you a rollup rate and you come away thinking your money is growing at that rate, one of you has misunderstood the contract, and it may not be you.

Both numbers are legitimate. The problem is presenting one and letting you assume it means the other. Ask directly: "If I cancel this in five years, what check do I receive?" The answer to that question is the account value less any surrender charge, and it is the number that tells you what you actually own.

What "guaranteed lifetime income" does and does not promise

It does promise that a defined payment continues for as long as you live, even if the underlying account value runs to zero, subject to the terms of the contract. That is a real thing and it is not available from a portfolio. A portfolio can run out. A properly structured lifetime income benefit does not.

It does not promise growth. It does not promise you will beat the market, and over long periods it usually will not. It does not promise liquidity. And unless you specifically purchase an increasing income option, it does not promise the payment will keep up with inflation. A fixed $2,400 a month is worth meaningfully less after twenty years of even modest inflation, and that is worth thinking about at sixty-five when you may be planning for thirty years.

The costs, stated plainly

Every guarantee is paid for. Usually in some combination of these:

Rider charges. A guaranteed income rider typically carries an annual fee deducted from the contract. Ask what it is, whether it can increase, and what it is charged against, because a fee charged against the benefit base rather than the account value is a larger fee than it appears.

Limited upside. In indexed products your return is linked to an index but limited by caps, participation rates or spreads, and you generally do not receive dividends from that index. Those limits can usually be changed by the company after the first year, within contractual bounds. Ask what the guaranteed minimum is, not just the current rate.

Surrender charges. Most contracts carry a surrender period, commonly somewhere between five and ten years, during which withdrawing more than the free amount costs you a percentage that declines over time. Most contracts allow a free withdrawal each year, often around ten percent. Some also apply a market value adjustment which can move the surrender value up or down with interest rates.

Taxes. Withdrawals from a non-qualified deferred annuity are generally treated as interest first and taxed as ordinary income rather than at capital gains rates, and withdrawals before age fifty-nine and a half may carry an additional ten percent federal penalty. Annuitized payments are treated differently. This is genuinely complicated and it is a question for your tax professional, not for me.

Questions worth asking before you sign anything

Any advisor should answer all eight without hesitating. If a question produces a change of subject, you have learned what you needed to know.

When an annuity is the wrong answer

If your guaranteed income already covers your essential expenses, you may not need more of it. If you are likely to need access to the money within the surrender period, the charges will probably outweigh the benefit. If your primary goal is leaving the largest possible estate rather than securing income, other tools generally serve that better. And if you cannot explain the contract to your spouse in your own words after the meeting, that is a reason to slow down, not a reason to trust the person explaining it.

I say no to people. It is a smaller part of the job than saying yes, but it is part of it.

This article is general education and is not tax, legal, or investment advice, nor a recommendation to buy or surrender any product. Annuity contracts vary considerably by product, carrier and state, and only the contract and its disclosure documents govern. Consult your own tax professional regarding your circumstances.