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Monday, June 17, 2024

What is an annuity & how does it work?

What is an annuity & how does it work? 


If you could purchase a product that promised to give you a steady income for life and take the worry out of outliving your assets, would you jump at the chance? An annuity is a product typically used to achieve this goal. While purchasing an annuity may sound like an easy decision, an annuity may not be appropriate for everyone.

What is an annuity?

An annuity is an insurance contract that is designed to provide a guaranteed income and is primarily used for retirement planning. In the world of personal finance, however, the guarantees associated with insurance products can carry hefty price tags, and they can also come with a lot of risk. Annuities are no exception. It is important to fully understand the pros and cons of these products before deciding whether or not an annuity is right for your investment portfolio. Additionally, these products are sold by brokers who receive sizeable commissions for selling these products. Before buying, it may be in your best interest to consult a fiduciary financial advisor before entering a contract subject to a surrender charge period.

How does an annuity work?

Annuities are designed to offer a reliable stream of income for retirees, ensuring peace of mind and security against the possibility of outliving their savings and assets. Recognizing that retirement funds may fall short of maintaining their desired lifestyle, some people opt to explore annuity contracts offered by insurance companies or other financial institutions. Upon activating the income stream, annuity contracts transfer some of the risk of a down market to the insurance company. This means the income stream, once activated, should be protected from market risk, and the income stream could always be there for the annuitant.

Typically, annuities go through two different phases: the accumulation phase and the annuitization phase.

The accumulation phase is the period when an annuity is being funded, but before payouts begin. Money invested in the annuity grows based on the type of money that was entered into the contract. Traditional IRA assets grow tax-deferred, Roth IRA assets grow tax-free, and non-qualified assets grow as such. However, annual taxes are usually avoided in non-qualified annuities because there are not ongoing dividend payments and capital gains distributions, such as with a non-qualified brokerage account.

The annuitization, or “pay out,” phase, is the period when your income stream begins. The income stream could be through actual annuitization, where the owner and annuitant give up access to liquidity in exchange for an income stream. However, some annuities offer living benefit riders, where the owner still has access to the remaining cash value until the income stream depletes the balance.

What types of annuities are there?

There are two basic types of annuities – immediate and deferred.

Immediate annuity

An immediate annuity provides a guaranteed stream of income right away. The owner puts a lump sum to an immediate annuity contract that can pay an income monthly, quarterly, or annually.

Deferred annuity

If someone wants to generate an income stream at a later date, they can get a deferred annuity. The assets are invested in a number of ways, depending on the type of deferred annuity, and the future income stream is affected by a variety of factors. This investment can be made as a lump sum or a series of purchase payments.

There are four major types of deferred annuities: fixed, fixed index, variable index and variable. These different types of contracts invest the assets differently.

  • Fixed – Your money will earn a fixed interest rate set by the insurance company. The interest rates are not typically high, but there is little downside risk, and when you begin receiving income, a fixed payment is guaranteed. Fixed annuities are a very conservative product.
  • Fixed index – Your money can track a variety of traditional and newly manufactured indexes for a period called a crediting term, such as 1-year, 2-year, 5-year, etc. At the end of the crediting term, the contract value is credited, based on the performance of the index, but this is subject to parameters that put considerable limitations on growth. These parameters include participation rates, cap, spreads, and charges.
  • Variable index – Similar to a fixed index annuity, a variable index annuity tracks a variety of different indexes for a period, and it is still subject to participation rates, caps and other rates, but it has more downside risk, which can be buffered.
  • Variable – In a variable annuity, your money will be divided and invested into variable sub-accounts, which are essentially mutual funds. The allocation is dependent on your risk level. Variable annuities may pay a guaranteed minimum income based on the annuity value and performance, but they still carry the downside risk of mutual funds, and they usually have substantially higher fees than traditional investment vehicles.

Read more: Term life vs. whole life insurance: What's the difference?

Key considerations

Annuities typically come with a surrender charge period, which is the amount of time an investor must wait before they can withdraw funds without being charged a penalty. This period generally spans anywhere from four to 12 years, and some are even longer. It’s important to consider there is an inherent liquidity risk when entering into a contract with a surrender charge period. If you encounter any events that require significant amounts of cash during this period, and you need to surrender the annuity, you could lose significant principal. If this is likely, you might also want to evaluate if you’ll still be able to afford to make the requisite annuity payments.

What’s more, annuity contracts may come with a living benefit rider, which is an optional feature that you can use with deferred annuities. The rider has a shadow account, typically referred to as a benefit base or income base, which is not a value that the owner has access to as a lump sum, but, rather, it is used in the calculation of a guaranteed income stream. The income still comes out of the contract value until that value is depleted, at which time the insurance company continues to make the payments. When purchasing a product with a living benefits rider, it is important to consider: 

  • What age you will need the income, as payment terms and interest rates may vary depending on the duration of the annuity.
  • What fees are associated with the income rider, as most living benefits riders come with high fees in exchange for the guarantees. These fees directly affect the growth of contract values.

What are the advantages and the disadvantages?

Annuity advantages

  • Peace of mind that you have a lower risk of outlive your retirement income
  • With a variable annuity you can take risks (via the underlying investment options) and still have control of the outcome (via the option of guaranteed minimum income)
  • There is no yearly contribution limit for a non-qualified annuity meaning you can store away large amounts of cash and defer paying annual dividend and capital gains taxes during the accumulation phase
  • The guarantees associated with annuities are backed by the insurance company
  • You have different options for how the assets are invested

Read more: How much should I save for retirement?

Annuity disadvantages

  • Annuities are expensive: Whether through direct fees - like insurance costs, administrative fees, rider charges and fund fees - or through opportunity costs – like those caused by participation rates, caps, spreads, and charges – annuities can be very costly.
  • Surrender charge periods: Annuities typically come with a surrender charge period, and if the owner needs to terminate the contract during that time, there will be a penalty charged on the withdrawal.
  • Annuities have tax implications: Income from Traditional IRA annuities is taxable as ordinary income, and can create problems when someone wants to, but cannot, turn off the income stream. Roth IRA annuities can defeat the point of a Roth IRA, which is maximizing long-term, tax-free growth. Finally, gains from non-qualified annuities are taxed as ordinary income, which is at a higher rate than long-term gains in a non-qualified brokerage account. Gains in non-qualified annuities are also subject to a 10% tax penalty, like a Traditional IRA, if withdrawn before Age 59 ½.

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. It is important that you should never feel rushed to purchase a product with a surrender charge period.

So, before you buy an annuity, make sure you understand what you’re buying and do your research, if you believe you are a good candidate for the product. If you need assistance with this, talk to a fiduciary 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?
  • What are the current and future tax implications of the product?

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.

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Daniel Kuhl


Daniel Kuhl is an Insurance Specialist at Empower. He is responsible for providing clients and advisors with robust insurance advice and analysis.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. No part of this blog, nor the links contained therein is a solicitation or offer to sell securities. Compensation for freelance contributions not to exceed $1,250. Third-party data is obtained from sources believed to be reliable; however, Empower cannot guarantee the accuracy, timeliness, completeness or fitness of this data for any particular purpose. Third-party links are provided solely as a convenience and do not imply an affiliation, endorsement or approval by Empower of the contents on such third-party websites.

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