What Is an Annuity and How Does It Work?

What Is an Annuity and How Does It Work?

Planning for expenses during retirement requires careful consideration of the many financial products available on the market. Every person's situation is different, so the best way to start this process is by taking stock of your unique financial needs and lifestyle goals.

You're likely considering some forms of insurance, but annuities are another common option that can help you support yourself and your loved ones after you retire. So what is an annuity, exactly?

What Is an Annuity?What is an annuity?

An annuity is a legal contract with an insurance provider that involves you making upfront payments — either through a lump sum or periodic premium payments — that are then distributed by the insurance company to you right away or at a later date. Buying an annuity typically involves using a portion of your retirement savings — or sometimes the cash value of a permanent life insurance policy — to purchase the contract.

After purchasing it, you may have the option of tailoring the agreement to fit your needs. For instance, you may be able to decide when and how payments will be made to you. Immediate annuities are often purchased by people of a range of ages who have received a large lump sum of money and who want to get more cash now and in the future. Deferred annuities give you flexibility with the option of payouts being delayed until a future date that works for you. Your principal — or upfront original investment — can grow over time and potentially increase your payouts, making annuities an attractive tool in planning for retirement income.

Annuity payments can be made to you for as long as you live. People nearing retirement age or looking to protect their investment portfolio from market ups and downs can make their annuity part of a reliable income stream.

As the annuity holder, you can also decide how your money will grow, or the potential rate of return and the basis for this return. This number can be based on several potential factors, including interest rates, underlying securities (a term for tradable financial assets that hold monetary value, such as stocks or bonds) that the annuity references for rates, the way the market performs and more.

Common Types of Annuities

Annuity structures can vary, so you'll be able to find one that fits your personal investing needs. The three main types of annuities are fixed, indexed and variable. The structures of these annuities may impact your rate of return and exposure to risk.

Fixed Fixed interest rate  Least risk

Minimum interest rate, plus a rate capturing the
market performance of tracked stocks

More risk
Variable Variable interest rate  Most risk

Fixed annuities offer rates based on the yield from investments that the insurance company holds, such as government and high-quality corporate bonds. The rates offered by variable annuities are based on the performance of a selected portfolio of stocks, while rates for indexed annuities combine a minimum rate along with a rate based on the performance of an index, or a group of stocks intended to represent a certain area of the stock market.

Because fixed annuities may be based on bonds or fixed income investments, returns may not benefit from strong stock markets and can be negatively affected by low interest rates. In contrast, because variable annuities are based so much on the stock market, they may offer larger returns and potentially larger income. However, with this potential reward comes the large risk of your account fluctuating with stock market performance.

An indexed annuity combines some of the best aspects of fixed and variable annuities and so offers a minimum rate plus a rate that may allow you to reap some of the benefits of rising markets. Retirement planners and long-term savers may find indexed annuities particularly attractive during times of low interest rates and volatile markets. You may even want to consider indexed annuities as an alternative to fixed-income investments such as bond funds — they could potentially protect you against inflation.

Note that variable annuities are regulated by the SEC and, because of their structure, they're considered securities. Because of this, brokers who sell variable annuities are required to have a securities license. By contrast, fixed and indexed annuities are typically not considered securities and are therefore regulated by state insurance commissions.

How Annuities Can Fit Into Your Retirement Plan

Consistent income is often a vital part of a plan for a long and enjoyable retirement. However, during times of economic uncertainty and rising costs of living, making enough progress toward retirement savings goals can be a challenge.

Annuities can allow you to maximize lifetime income because you are:

  • Hedging against longevity risk, or the possibility of outliving your savings.
  • Minimizing the risk of your income decreasing during market downturns.
  • Boosting your retirement nest egg with a tax-deferred earnings increase on your savings.
  • Diversifying — or spreading risk — across your portfolio.

You can also purchase customized additions to your annuity contract, which are called riders, to give you additional flexibility. For example, a cost of living rider might use the consumer price index (a standard measure to estimate inflation) to adjust the annual cash flows you could receive. You can also use a rider to accelerate payouts if you face a terminal illness, and a death benefit rider can be added for paying a specified minimum amount (e.g., your total purchase payments) to a beneficiary.

Annuities can carry some risks, including market risk and the potential to lose the principal. Because of this, it's important to review your life goals and potential life changes along with the total cost when selecting an annuity. Think about how annuities you're considering compare with other financial tools. A financial advisor can help you see this overall picture and help you understand how an annuity may work for you.

What You Need to Know About Annuities

To understand annuities, keep in mind that when you make an annuity contract, you're exchanging a liquid sum of money — i.e., money that you can access right now — for a series of payments in the future, which you can look at as insurance for retirement. Your deposit will typically undergo a surrender period, during which you may incur a penalty if all or part of that money is withdrawn.

It's also important to pay attention to the terms of your annuity. You'll want to find out how much monthly income you're likely to receive based on the sum you plan to invest. Additional considerations include:

  • How rates of return are determined and how you can verify these returns.
  • What expenses, commissions and fees you may be charged.
  • What happens to the payout in potential scenarios such as your spouse outliving you.

You don't pay taxes on the money while it's in the annuity — this usually happens only when you withdraw it, similar to a 401(k) or individual retirement account (IRA). However, payouts and profits during early withdrawals may be treated as taxable income instead of as capital gains (the profits resulting from the sale of an asset), which are not taxed the same. A tax professional can help you determine what your annuity would mean for your taxes.

Understanding the financial strength of the insurance company that's promising payouts to you should also be a part of your annuity purchase. Learn more about how the company's doing by consulting reputable, independent sources and inquiring if the company has a protection plan against default, such as reinsurance.

Build Your Portfolio to Last

Your retirement lifestyle and goals will determine how much you may need in savings. Before deciding how much of your money will go to financial instruments like stocks, bonds or other assets, take some time to consider how annuities could also help you achieve those goals.


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