What Is an Annuity? A Fee-Only Fiduciary’s Skeptical Buyer’s Guide

An annuity is a financial product issued by an insurance company that converts a lump sum or series of payments into a guaranteed income stream, either immediately or at a future date. For retirees worried about outliving their savings, certain annuities can serve a real purpose. But the annuity market is dominated by commission-driven sales, and the vast majority of annuities sold are not the kind a fee-only fiduciary would recommend.

Q3 Advisors is a fee-only Registered Investment Advisor. We do not sell annuities. We do not earn commissions when clients buy them. That structural independence is why we can give you the honest version of how annuities work, when they make sense, and when they almost certainly do not. This article takes a deliberately skeptical-buyer stance because that is the stance any sophisticated retiree should bring to an annuity sales pitch.

How Annuities Work

When you purchase an annuity, you transfer money to an insurance company in exchange for a promise of future income payments. Those payments can begin right away (an immediate annuity) or years down the line after a period of tax-deferred accumulation (a deferred annuity). The income stream may last for a defined term, for your lifetime, or for the joint lifetimes of you and your spouse.

Annuities have two phases: the accumulation phase, during which your premium grows according to the product type, and the distribution phase, when payments flow back to you. The terms, guarantees, and costs differ substantially across product types, which is why the stated payout rate is almost never the right number to compare. Total cost of ownership, surrender flexibility, tax treatment, and counterparty risk all matter as much as the headline rate.

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The Commission Problem You Should Understand Before You Read Anything Else

Most annuities sold in the United States pay the agent or “advisor” recommending them a substantial upfront commission, typically 5% to 9% of the premium, sometimes more on indexed and variable products. The commission is paid by the insurance company out of long-term spreads, surrender charges, and product fees. You don’t see it on a statement, but you pay for it in lower payouts, longer surrender periods, and higher internal costs.

This commission structure shapes the annuity advice most retirees encounter. The “advisor” recommending the product is often a licensed insurance agent, not a fiduciary. Even CFP® professionals can earn annuity commissions if their firm permits it. The result is predictable: variable annuities and fixed indexed annuities, the highest-commission products, are dramatically oversold relative to where they actually fit, while low-cost SPIAs and QLACs are undersold because they pay smaller commissions.

If you take one thing from this article, take this: the cost of the advice is built into the product. Whenever someone is recommending an annuity, the first question to ask is how they get paid.

Types of Annuities and How They Stack Up

The annuity market includes several product categories with very different cost and complexity profiles. Skeptical buyers should evaluate each through the lens of total cost, liquidity, and whether the structural problem the product claims to solve actually exists in their plan.

• Single Premium Immediate Annuity (SPIA): You pay a lump sum, income begins within a month or two, and payments continue for life or a defined term. SPIAs are the simplest, most transparent, and lowest-cost annuity structure. Commissions are modest (often 1-3%), there are no ongoing fees, and the math is straightforward. For retirees who genuinely need to convert savings into guaranteed income, a SPIA is usually the cleanest tool.
• Deferred Income Annuity (DIA / Longevity Annuity): Income begins far in the future, such as age 80 or 85. Low cost relative to the longevity protection it provides. The most common version held inside an IRA is a Qualifying Longevity Annuity Contract (QLAC), discussed in detail below.
• Fixed Annuity (Multi-Year Guaranteed Annuity, MYGA): Pays a fixed interest rate for a guaranteed period (often 3-7 years). Functions like a CD with tax deferral. Predictable, low-risk, low-cost, but growth potential is limited and may not keep pace with inflation. Reasonable for the right slice of a fixed-income allocation when the rate is competitive with comparable-maturity Treasuries.
• Fixed Indexed Annuity (FIA): Growth is linked to a market index like the S&P 500, with a floor protecting against principal loss. The marketing is compelling, “market upside without market downside”, but the reality is more nuanced. Participation rates (often 50-70%), caps (often 5-9% per year), and spread fees substantially limit the upside. Surrender periods commonly run 7-10 years with surrender charges of 7-10%. Commissions are among the highest in the industry. The SEC, FINRA, and state insurance regulators have all issued warnings about FIA sales practices specifically. For most fee-only fiduciaries, FIAs do not pass cost-benefit analysis.
• Variable Annuity: Earnings depend on the performance of underlying investment subaccounts (similar to mutual funds), often with optional living-benefit riders that guarantee minimum income or withdrawal levels. All-in costs commonly run 2% to 3.5% per year (mortality and expense charges, administrative fees, subaccount fees, rider fees combined). Distributions are taxed as ordinary income with no step-up in basis at death, meaning heirs lose the basis adjustment they would have received on the same money held in a brokerage account. Variable annuities are the most over-sold product in the category, and fee-only fiduciaries almost universally avoid them outside very narrow exchange-1035 use cases.

Pros: When Annuities Genuinely Add Value

For the right client at the right stage of retirement planning, annuities can solve specific problems that other products do not. These are the legitimate use cases.

• Longevity insurance for retirees with no pension. A SPIA or QLAC can convert a portion of savings into guaranteed lifetime income, eliminating the risk of outliving your money. This is the single most defensible reason to buy an annuity. If you have no pension, modest Social Security, and a real fear of running out, allocating 20-30% of retirement savings to a SPIA or QLAC can solve that problem in a way nothing else does.
• RMD deferral via QLAC. A QLAC held inside an IRA can defer up to $210,000 of your IRA balance from RMD calculations until age 85 (this is the 2026 limit, indexed for inflation under SECURE 2.0). For IRA millionaires actively trying to reduce RMD-driven taxable income, and the IRMAA Medicare surcharges that come with it, the QLAC is one of the few annuity strategies worth serious evaluation. The math often coordinates well with multi-year Roth conversions; see our framework on critical insights on Roth conversions and RMDs.
• Spousal income protection. Joint-and-survivor SPIA payout options ensure income continues to your spouse after you pass. For couples where one spouse depends financially on the other, this can be a meaningful piece of retirement income planning that other products do not replicate as cleanly.
• Behavioral floor in a market downturn. A guaranteed income stream covering essential expenses can reduce the temptation to sell equity holdings at the bottom of a market drawdown. This is real, but should not be confused with “principal protection”, a SPIA gives up your principal entirely in exchange for the income stream.

Cons: The Structural Problems Buyers Underestimate

The drawbacks below are not edge cases. They are the dominant economics of how the annuity industry works.

• Costs that compound for decades. Variable annuities commonly run 2-3.5% in all-in annual costs (M&E + administrative + subaccount + rider). Over 20 years, that compounding cost differential versus a low-cost index portfolio can consume 30-50% of total returns. FIAs hide their costs in caps, participation rates, and spread fees rather than disclosing an explicit expense ratio, but the economic effect is similar.
• Surrender charges and lock-up. Most annuities impose 5-10 year surrender periods with charges of 7-10% of contract value during the surrender period. You generally have a 10% free-withdrawal allowance per year, but anything above that triggers the surrender charge. This makes annuities highly illiquid relative to a brokerage account or even a CD ladder.
• Ordinary income taxation, no step-up at death. Gains distributed from a non-qualified annuity are taxed as ordinary income, not at the lower long-term capital gains rates. At death, heirs do not receive a step-up in basis on annuity gains, they inherit the same ordinary-income tax liability you would have owed. For appreciated assets that would otherwise pass to heirs with a basis step-up, holding them inside an annuity wrapper actively destroys tax value.
• Inflation risk on fixed payouts. Fixed income payments rarely include automatic inflation adjustments. A $5,000 monthly SPIA payment that seems adequate today buys substantially less in 20 years. Some annuities offer inflation-adjusted (cost-of-living) options, but the initial payout is meaningfully lower.
• Counterparty risk. Annuities are backed solely by the insurance company’s claims-paying ability, not by FDIC, SIPC, or any federal program. State guaranty associations provide some protection if an insurer becomes insolvent, but coverage is typically limited to $250,000 of present value annuity benefits per insurer per state (with $300,000 limits in some states). For larger annuity allocations, splitting across multiple highly-rated insurers is essential.
• Complexity that benefits the seller. A typical variable annuity contract runs 100+ pages with riders, sub-account fee schedules, and surrender provisions that are designed to be hard to compare. This complexity is not accidental, it makes the product harder to evaluate against simpler alternatives.

When an Annuity Makes Sense for the IRA Millionaire ICP

For Q3’s typical client, a pre-retiree or retiree with $1M+ in traditional IRA assets, annuities pass cost-benefit analysis in only a narrow set of circumstances. We routinely evaluate them and most often recommend against them. Here are the specific situations where the math actually works.

• You have no pension and are genuinely worried about longevity risk. If you have no defined-benefit pension, modest Social Security, and a family history of long life expectancy, allocating 20-30% of retirement savings to a SPIA or QLAC can convert “running out of money at 92” from a real risk to an impossible one. This is what annuities are actually for.
• You want to reduce RMDs from a large traditional IRA. A QLAC held inside the IRA can defer up to $210,000 (2026 limit) from RMD calculations until age 85. For IRA millionaires whose RMDs would push them into higher brackets and trigger IRMAA Medicare surcharges, the QLAC can produce real lifetime tax savings. This strategy generally works best when combined with a multi-year Roth conversion plan, the conversions reduce future RMDs from the bulk of the IRA, and the QLAC defers RMDs on the small carved-out portion.
• You are funding essential expenses for a non-investment-savvy spouse. If you predecease your spouse and they would not be comfortable managing a brokerage portfolio, a joint-and-survivor SPIA can deliver income that arrives without their needing to make any decisions. This is a legitimate behavioral solution to a real risk.

When an Annuity Almost Certainly Does Not Make Sense

• You are being sold a variable annuity for “tax deferral” inside an IRA. IRAs already provide tax deferral. Wrapping an annuity inside an IRA adds 2-3.5% per year of cost for zero incremental tax benefit. This is one of the most common abuses in the industry, and the FINRA position on it is unambiguous.
• You are being sold an FIA on the promise of “market gains with no losses.” The participation rate, cap, and spread fees mean you typically capture 30-60% of index returns at best. After surrender charges and the opportunity cost relative to a low-cost balanced portfolio, the math rarely works for a buy-and-hold investor.
• You have substantial guaranteed income from other sources. If your Social Security, pension, and other guaranteed income already cover 70%+ of essential expenses, the longevity-insurance argument for an annuity is weak. Additional savings are better deployed for growth and flexibility.
• You need liquidity. Annuities are illiquid by design. If there is meaningful chance you will need access to the principal for healthcare costs, family needs, or opportunistic investments, the surrender penalties make annuities a poor fit.

A Note on Annuities Inside IRAs

A common question is whether to hold an annuity inside a traditional IRA. From a pure tax-deferral perspective, the answer is no, IRAs already grow tax-deferred, so an annuity inside an IRA adds cost without adding tax benefit.

The QLAC is the meaningful exception. By specific IRS rule, money used to purchase a QLAC inside an IRA is excluded from RMD calculations until payments begin (no later than age 85). For IRA millionaires whose RMDs would otherwise force unwanted income into high tax brackets, the QLAC is the one annuity-inside-IRA strategy that creates real value.

A few QLAC technical points worth knowing for 2026:

• Maximum lifetime contribution: $210,000 per person, indexed for inflation (was a flat $200,000 as introduced under SECURE 2.0; now indexed)
• Income must start by age 85
• Funds can come from traditional IRAs, 401(k)s, 403(b)s, and 457(b)s, not from Roth IRAs
• Married couples can each hold their own $210,000 QLAC, sheltering up to $420,000 from joint RMD calculations
• The contract must be a fixed annuity, variable and indexed annuities do not qualify as QLACs
• Note: RMD age depends on birth year. If you were born 1951-1959, RMDs begin at age 73. If you were born 1960 or later, RMDs begin at age 75 under SECURE 2.0.

Frequently Asked Questions

Are annuities safe investments?

Annuities are backed by the financial strength of the insurance company that issues them, not by the FDIC. Most states participate in life and health insurance guaranty associations that provide some protection (typically up to $250,000 of present value annuity benefits per insurer, with higher limits in some states) if an insurer becomes insolvent. Purchasing only from highly rated carriers (A or better from AM Best) and splitting larger allocations across multiple insurers are both important risk-management practices.

How are annuities taxed?

Qualified annuities, funded with pre-tax money from an IRA or employer plan, are taxed as ordinary income on all withdrawals. Non-qualified annuities, funded with after-tax dollars, are taxed only on the earnings portion using an exclusion ratio. Neither type receives capital gains treatment on earnings, and neither receives a step-up in basis on gains at death. This makes annuities a tax-inefficient vehicle for assets you otherwise plan to leave to heirs.

Can I get out of an annuity if I change my mind?

Most annuities include a free-look period during which you can cancel without penalty, typically 10 to 30 days, with California requiring 30 days for buyers age 60 and over on most products. After the free-look period, surrenders during the surrender period (often 5-10 years) incur charges of typically 7-10% of contract value. Most products allow penalty-free withdrawals of up to 10% of the contract value per year, and many waive surrender charges in cases of terminal illness or confinement to a nursing facility.

What is the difference between an annuity and life insurance?

Life insurance is designed to protect against dying too soon by providing a lump sum to beneficiaries. Annuities are designed to protect against living too long by providing income you cannot outlive. Some hybrid products combine features of both. Each product solves a different financial problem, and treating them as substitutes is a common mistake.

Is it true that fee-only fiduciaries don’t recommend annuities?

This is too strong. Fee-only fiduciaries do recommend annuities, but typically a narrow subset (low-cost SPIAs, plain-vanilla fixed annuities, and QLACs) and only when the structural use case (longevity insurance, RMD deferral, spousal income protection) is clearly present. What fee-only fiduciaries generally do not recommend are variable annuities and fixed indexed annuities, where the cost structure rarely justifies the benefits relative to alternatives. 

The distinction is between the category of annuities (mixed, with both useful and abusive products) and the specific products most commonly sold (skewed heavily toward the abusive end). For more on what to look for in a fiduciary advisor, see our overview of what a Certified Financial Planner is and what fiduciary status means.

Talk to a Fee-Only Fiduciary Before You Buy an Annuity

Annuities can be powerful retirement income tools in narrow circumstances. They can also be among the most expensive financial mistakes a retiree makes. The difference comes down to the specific product, the specific use case, and whether the person recommending it has structural incentives to sell.

Q3 Advisors is a fee-only Registered Investment Advisor led by Craig Wear, CFP®. We do not sell annuities, do not earn commissions when clients buy them, and have no incentive to recommend them when the math does not work. We do help IRA millionaires evaluate when an annuity (almost always a SPIA or QLAC) makes sense as part of a broader plan, and we coordinate that evaluation with the Roth conversion strategies and tax planning that drive most of our work.

Call us at (720) 730-5650 or schedule a consultation online to get an honest review of your retirement income options, including whether any annuity at all belongs in your plan.