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Wednesday, February 28, 2024

What is an annuity & how does it work?

What is an annuity & how does it work? 

05.31.2022

Most adults have checking and savings accounts and know how to buy a certificate of deposit. However, if you ask them what an annuity is, you will probably get some shrugs.

Annuities are often misunderstood. In this article, we’ll cover the basics of the different types of annuities, how they work and whether annuities might be a good investment for you.

What is an annuity?

An annuity is an insurance contract that provides a guaranteed stream of income for a specified period or for life. A guaranteed steady stream of income is the holy grail of financial planning, so why isn’t everyone buying an annuity? Because any type of “guarantee” comes at a higher cost, and not every product is right for every investor. On top of that, annuities are complex, and there are different varieties of annuities with hundreds of options, riders, disclaimers, footnotes and contingencies.

A financially savvy person saving responsibly for retirement might be able to use other retirement products and other types of investments instead of buying an annuity. If you have retirement savings, you can start drawing down from those assets, but there is always the risk of running out of money before you die.

How do annuities work?

To understand how annuities work, you first need to understand the two main types:

1. Immediate annuity

If you need a guaranteed stream of income right away, you can convert a lump sum of money to an immediate annuity that pays out monthly, quarterly, semi-annually or annually. You can opt to get payments for a fixed number of years or until you die.

2. Deferred annuity

If you are years away from retirement and want to make sure you have a guaranteed income source in retirement, you can get a deferred annuity. Any investment growth is tax deferred within the account — similar to your 401(k) — so you pay current taxes on the amounts you invest and then only on the gain when you begin to receive payments at a later date, usually in retirement.

More options to consider

Purchasing an annuity isn’t as easy as deciding whether you simply want an immediate or deferred annuity. Here are some more options you should consider:

  • Single premium — You buy an annuity using a lump sum of money.
  • Flexible premium — You make multiple premium periodic payments to the insurance company.
  • Fixed — Your money will earn a fixed interest rate set by the insurance company. When you begin receiving income, a fixed payment is guaranteed.
  • Variable — Your money will be split into sub-accounts as you direct, depending on your risk level and invested in stocks, bonds or other investment options. The annuity pays a minimum level of income, which could go up depending on the performance of the sub-accounts. The downside is higher fees; these typically have substantially higher fees than investing directly in mutual funds.
  • Equity-indexed — With this variation of a fixed annuity, the interest rate is based on an outside index, such as a stock market index. Like variable annuities, this product pays a minimum rate, which might go up to a certain cap if the index performs well, with other complexities typically built into the product,

You also might want to consider how long of a payout you want; whether you want a portion to go to your beneficiaries for a designated period of time when you die (“a period certain” annuity payout), or an installment refund rider (discussed below):

  • Lifetime income — You receive income as long as you live, even if payments exceed the amount of money you put into the account. If you buy an installment refund rider, your beneficiaries will continue to receive payments even after you die until the death benefit paid to you and your beneficiaries equals the premium. If you did not purchase a rider, or select a period certain annuity payout, the insurance company will keep the remaining assets in the contract or the unreimbursed premium.
  • Joint and lifetime income — Provides income as long as you or  your survivor lives.

Annuity benefits

There are benefits and drawbacks to these types of accounts. A few of the key benefits of an annuity include:

  • There are no contribution limits, unlike 401(k) plans and IRAs.
  • You can save money today by not paying taxes on any earned income until a later date.
  • With an annuity, you may not have to worry about outliving your savings.

Our take

As with any contract you sign or any financial product you buy, it’s always wise to ask questions and thoroughly understand what you’re buying.

So, before you buy an annuity, make sure you understand what you’re buying and that you’ve done your research and believe you are a good candidate for the product. (If you need assistance with this, talk to a financial professional). Also make sure you are buying a product that is suitable for your needs and matches your goals, and that you’re buying it from the best possible source, taking fees and risks into consideration.

Here are a few questions to ask as you perform research:

  • How will an annuity help my retirement?
  • Is the annuity adjusted for inflation?
  • What is my risk tolerance, and how will buying an annuity influence this versus investing in a mutual fund?
  • How much money should I put into an annuity?
  • What is the rating and strength of the annuity issuer, and what are the fees?

If you are considering purchasing an annuity, make sure you are aware of the potential benefits and drawbacks and how the annuity fits into your overall retirement plan. Being fully informed is crucial, so consider consulting a trusted financial professional to help you understand the complex world of annuities.

 

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