An annuity is a contract with an insurance company. You hand over money, either in one lump sum or in a series of payments, and in return the insurer pays you income, either starting right away or at some future date. People mostly buy annuities to turn savings into a predictable stream of retirement income. The trade-offs are fees, complexity, surrender charges, and the fact that the guarantee rests on the insurer, not the government.

What an annuity is

The US Securities and Exchange Commission describes it this way: "An annuity is a contract between you and an insurance company that is designed to meet retirement and other long-term goals." You buy one with a single payment or a series of payments, and the insurer agrees to make periodic income payments to you beginning immediately or at a future date.

An annuity generally has two phases. During the accumulation phase your money grows, and that growth is tax-deferred, meaning you pay no tax on the gains until you take the money out. During the distribution, or payout, phase the insurer pays income back to you. An immediate annuity starts paying almost at once; a deferred annuity starts later.

One warning sits at the center of the product. An annuity is not a bank deposit. The SEC notes that an insurer's obligations "are subject to its financial strength and claims-paying ability," and FINRA states plainly that annuities "aren't guaranteed by the FDIC, SIPC, or any other federal agency." If the insurer fails, a state guaranty association may cover part of your contract, but there is no federal backstop like the one on insured bank accounts.

The three main types

There are three broad kinds, and risk rises across them:

• Fixed annuities. The insurer guarantees an interest rate for a set period, so the return is predictable. FINRA notes the rate "can change over time" when the guarantee period ends. These are the simplest and are often compared with a certificate of deposit, though a CD is FDIC-insured and a fixed annuity is not.
• Fixed indexed annuities. Interest is tied to a market index such as the S&P 500, with downside protection but a cap or participation rate that limits how much of the index's gain you keep. FINRA calls indexed annuities "complex financial instruments."
• Variable annuities. Your money goes into investment options you choose, so you bear the market risk and the payout can rise or fall. FINRA says variable annuities are "a leading source of investor complaints."

What annuities cost

Costs are where annuities get complicated, and where the headline guarantee and the net result can diverge. Depending on the type, you may pay a mortality and expense risk charge, administrative fees, the investment expenses of the underlying funds in a variable annuity, and the cost of any optional riders such as a guaranteed lifetime income benefit. Sales commissions can be high and are often built into the contract rather than billed separately.

Surrender charges are the big one for anyone who might need the money early. FINRA says variable annuities "can feature surrender periods of eight years or more," and defines a surrender charge as "the penalty fee owed by a contract owner who sells or withdraws money from the annuity during the surrender period." Those charges typically start high and taper off year by year.

The tax rules, and the age-59½ trap

The tax-deferred growth is real, but it comes with strings. The IRS says withdrawals of earnings are taxed as ordinary income, and that you "may be subject to an additional 10% tax on early distributions" if you take money "before age 59½," with some exceptions such as death or disability. FINRA advises most investors to consider an annuity only after they have used up more conventional tax-advantaged retirement accounts, which is why a piece like our guide to a Roth IRA versus a 401(k) is often the first stop, not an annuity.

Immediate, deferred, and the inflation question

Timing is a second axis that cuts across the three types. An immediate annuity, usually bought with a single lump sum at or near retirement, starts paying income within about a year. A deferred annuity takes money now and begins paying at a chosen later date, leaving more time for tax-deferred growth. One risk is common to fixed payouts: inflation. A level payment that looks comfortable today buys less each year as prices rise, which is why some contracts offer an inflation-adjustment rider at an extra cost. As with every annuity feature, that rider trades some income now for protection later, and the price of the trade is written into the contract.

Who annuities suit, and how to compare one honestly

Annuities are built for a long time horizon and for people who value a predictable income more than access to a lump sum. The appeal is a paycheck you cannot outlive; the cost is flexibility, fees, and inflation risk on a fixed payout whose buying power shrinks over time. None of that makes them good or bad in the abstract, which is exactly why the SEC tells buyers to "review the materials you are given" and discuss the contract before signing.

If you are weighing one, ask for four things in writing: the total annual cost, the surrender schedule, the cap or participation rate on any indexed product, and precisely what is guaranteed and by whom. A product sold on "guaranteed income for life" can carry fees and limits that change the math a great deal, so the written numbers, not the sales pitch, are what to judge it on.