Economists have argued since the 1960s that many retirees would be better off turning much of their savings into an income for life, yet where the choice is voluntary, most retirees decline. Economists call that gap the annuity puzzle.

The short answer to how do annuities work: you pay an insurance company a lump sum or a series of payments, and in return it pays you an income that starts now or at a future date, for a set period or for the rest of your life.¹ You give up access to the money, and often pay fees you cannot see. With a lifetime annuity, you get protection against outliving your savings. Any offer comes down to three questions, answered in order below: when does the income start, who carries the market risk, and what does it cost, including to leave early?

The OECD’s Pension Markets in Focus 2025 reports that in many countries most payments from funded pension plans are one-off sums, which limits how far those plans protect people against a long life.² Like our other guides to retirement and financial independence, this one labels each rule and figure with its country; elsewhere, your own regulator’s guidance applies.

How do annuities work? A pool that pays whoever lives longest

A lifetime annuity is insurance against a long life. Many buyers hand money to an insurer, and the money of those who die early helps pay those who live long; the US regulator FINRA calls these leftover payments “mortality credits.”³ Pooling lets the insurer promise each survivor an income that no single person could safely promise themselves.

The economist Menahem Yaari showed in 1965 that, in a simple model where lifespan is the only uncertainty and nobody wants to leave an inheritance, a retiree should put all their savings into fairly priced annuities. Thomas Davidoff, Jeffrey Brown and Peter Diamond later found the result survives much looser conditions, as long as there is still no wish to leave an inheritance and annuities pay survivors more than comparable investments after costs. They add that public pensions such as US Social Security and defined benefit plans already pay out this way.⁴

Consider a made-up group of 70-year-olds. None knows who will reach 95, but an insurer can estimate how many will and spread the cost across the group. On your own, you must plan as if you might live to 100, which means spending less every year just in case.

So if you have a defined benefit pension, you already own something very close to an annuity: an income paid for life.

Immediate or deferred: when the income starts

The US Securities and Exchange Commission (SEC) explains that an immediate annuity is bought with a single payment and typically starts paying within a year, while a deferred annuity builds up value first, with growth taxed only later under US rules, before the income phase begins.¹

A deferred income annuity, which FINRA says is sometimes called longevity insurance, works like an immediate annuity with the start date pushed years ahead. Its payouts are generally larger than an immediate annuity’s, partly because some buyers die before payments begin and their money stays in the pool. Someone might use a slice of their savings at 65 to buy an income that starts at 85, then spend the rest more freely, knowing the far end is covered. FINRA’s 2022 guide lists the catches: the purchase is generally irreversible, most such contracts pay heirs nothing if you die before payments start, and payments generally do not rise with inflationinflation: A general rise in the prices of goods and services over time, so that the same amount of money buys less. Returns are often reported after inflation, in real terms, to show what a gain is worth in buying power.Full entry in the glossary unless you buy a rider that lowers them.³

The later the income starts, the more each unit of savings buys, and the longer that money stays out of reach if your plans change.

Fixed, indexed or variable: who carries the market risk

Deferred annuities differ mainly in who bears market swings while the money builds up. The SEC lists the four main US types in order of rising risk: fixed, fixed indexed, registered index-linked (often shortened to RILA) and variable. A fixed annuity promises at least a minimum interest rate set by the insurer. A fixed indexed annuity credits interest partly linked to a market index and never less than zero. A RILA can lose money when the index falls, within limits the insurer sets on both gains and losses. A variable annuity invests in funds you pick, with no limit on gains or losses.¹

The protection is paid for by giving up part of the gains. The SEC’s 2020 bulletin on indexed annuities shows how: with a 7 percent cap, an index return calculated at 12 percent credits only 7 percent. Many such contracts also measure the index without the dividends its shares pay, and the insurer can usually change features such as the cap from time to time.⁵

Ask any seller which way the risk runs: a guarantee is usually paid for with a limit somewhere else.

Where the costs and surrender charges hide

Annuity costs come in two forms, the SEC explains: explicit fees taken from the contract’s value, and implicit costs that are harder to see, such as crediting you less interest than the insurer earns on your money or capping your gains. In the SEC’s own example of a visible fee, a base contract fee of 1.25 percent a year on a contract worth $300,000 (US dollars) comes to $3,750 a year, and part of the profit on that fee sometimes pays the seller’s commission.¹ FINRA says a variable annuity’s yearly expenses are likely to be much higher than a typical mutual fund’s, and that these products are a leading source of investor complaints to the regulator.⁷

Surrender charges are the cost of leaving early. The SEC’s guide to variable annuities gives an example schedule: 7 percent in the first year, falling by a point a year, typically gone after six to eight years, though sometimes only after ten. US savers who withdraw before age 59½ may also owe a 10 percent federal tax penalty (as of 2026).⁸

Lifetime income annuities hide their price differently: inside the payout rate. Brown and colleagues note that payouts are typically below the actuarially fair level because of administrative costs and adverse selection, the tendency of people who expect to live long to be the likeliest buyers.⁹ Getting quotes from several insurers before you sign is a free check on the price.

WiserHours

Questions to ask before buying any annuity

• What does it cost in total, including surrender charges, caps and optional benefits?
• How long must I hold it to avoid surrender charges and tax penalties?
• Does the income last for life, and does it rise with prices?
• What happens to the money if I die early?
• How is the seller paid, and would an exchange start a new surrender period?
• How strong is the insurer, and what protection applies if it fails?
• Have I compared offers from other insurers?

Find this checklist online:
https://wiserhours.com/financial-independence/how-annuities-work/#checklist-how-annuities-work-questions

Why so few people buy one: the annuity puzzle

Where buying an annuity is voluntary, few people do, even though simple economic models predict strong demand. The OECD’s Pensions at a Glance 2025 notes that in Australia, Costa Rica and Israel, where annuitisation is not mandatory, large amounts are paid out as lump sums or programmed withdrawals instead.¹⁰

The UK, where savers have been free to choose since the 2015 pension freedoms, shows the same pattern. The Financial Conduct Authority’s figures for the year to March 2026 count about one annuity purchase for every four pension plans moving into drawdown, and cashing in a whole pot remained the most common first move. Nearly four in five of the annuities sold paid a level income with no built-in rise for inflation. The figures count plans, not people.¹¹

Brown and colleagues list the usual rational explanations: public pensions already provide a lifelong income for many people, some want to leave money to their families, savings may be needed for medical or care costs, prices can be high, and many annuities offer no protection against inflation.⁹

Psychology may explain more, as a survey that described the same choice in two ways suggests.

The study

Limited evidence

Spending or investing? One lifetime income, described two ways (US survey, 2007)

When a lifetime income of $650 a month (US dollars, 2007) was described in terms of what it let a person spend and until what age, 72 percent of respondents preferred it to a savings account of comparable actuarial value. When the same choice was described in investment terms, with returns and account values, only 21 percent did. Both figures are for versions where leftover money went to charity; with children as heirs, they were 59 and 12 percent.⁹

The authors argue that people judge annuities through an investment frameframing effect: The tendency for a choice to change when the same facts are described differently, for example as lives saved rather than lives lost. It is one of the effects that held up when large teams ran the original experiments again.Full entry in the glossary, where a contract that pays nothing if you die early looks like a losing bet, rather than as insurance for lifelong spending. So before comparing an annuity on returns, write down what it would let you spend each month, and until when.

Two cautions apply. The 2008 study by Brown, Kling, Mullainathan and Wrobel was part-funded by the TIAA-CREF Research Institute, the research arm of a US retirement provider that sells annuities, and the choices were hypothetical. And Alexandrova and Gatzert’s 2019 systematic reviewsystematic review: A review that fixes its question and its rules for including studies in advance, then searches out every study that fits and weighs them together. Some systematic reviews pool the results into a meta-analysis; others describe what the studies found without combining the numbers.Full entry in the glossary of 89 articles, whose abstract alone was available to us, concluded that the role of behavioral biases needs considerably more research and evidence, and that theoretical models already appear to explain observed annuitization rates well.¹²

Myth

An annuity is a bad bet because you lose your money if you die early.

Fact

A lifetime annuity is insurance: if you die early, your money helps pay people who live long. Options that pay heirs exist, but they reduce your income.

What a lifetime income still leaves exposed

A lifetime annuity removes the risk of outliving your money but leaves three others: rising prices, the insurer’s own finances and lost flexibility, since the purchase is usually hard to undo. Each can be reduced, usually at the cost of a lower income.

Inflation is the quiet one, since most UK annuities sold pay a level income.¹¹ On our own arithmetic, prices rising 2 to 4 percent a year would cut what a level payment buys by roughly a fifth to a third within 10 years. A level income that covers a full weekly shop at 66 would cover only about four-fifths of it at 76 if prices rose 2 percent a year. Inflation protection lowers the starting income, FINRA notes.³

The promise is only as strong as the company behind it. FINRA reminds US buyers that an annuity’s guarantee lasts only as long as the insurer stays in business, and that no federal agency such as the FDIC backs it, though state guarantees may apply if an insurer fails.⁷ Those state guaranty funds may not cover the full loss, FINRA adds.³ In the UK, the Financial Services Compensation Scheme (FSCS) says it can generally protect annuities from UK-regulated insurers and, where it pays out, covers them in full with no upper cap (as of 2026).¹³ Elsewhere, ask which protection scheme, if any, covers the insurer before you buy.

Keeping savings invested instead leaves you exposed to sequence risk, the danger that early market falls do lasting damage, as our guide to what financial independence means explains. Davidoff and colleagues’ theory suggests that buying some annuity income can be worthwhile even when converting all of your savings is not.⁴ Any lifelong income also shrinks the gap your savings must fill, and with it the savings target behind an FI number. One practical way to weigh all this: list the bills you must pay whatever happens, see how much of them a state or workplace pension already covers, and consider buying lifelong income only for what is left.

Ask any seller which way the risk runs: a guarantee is usually paid for with a limit somewhere else.

How solid each answer is

Each row gives the strongest source for one question.

Who to ask before you sign

An annuity is usually hard to undo, so check the seller and get advice before you sign. The routes below are US and UK examples from official sources; elsewhere, start with your national financial regulator or public pension service.

• Now: if a seller presses you to decide quickly, or to swap an annuity you already own for a new one, pause; the checklist questions above apply to any replacement too.
• Soon, before buying: our suggestion is to see a fee-only or otherwise regulated adviser who earns no commission on the sale, and to ask any adviser how they are paid. BrokerCheck, a free FINRA service in the US, lists customer disputes and disciplinary events on a broker’s record.¹⁴ For the UK, the regulator’s online Firm Checker shows if a firm has FCA permission to sell you a given product or service.¹⁵
• Routine: people in the UK over 50 can get a free Pension Wise appointment (as of 2026) on their pension choices; its scope excludes the State Pension and pensions of the “final salary” or “career average” kind.¹⁶

The bottom line

Think of an annuity as buying certainty about income with money you can no longer touch, at a price that is often hard to see. If you are weighing one, work out first which essential bills it would need to cover, then compare quotes across insurers, check how the income keeps up with prices and what leaving early costs, and take regulated advice before a decision you cannot easily reverse.