Annuities are one of the most underutilized elements of retirement strategies. For many people, their first question when they hear the word annuity is “How do annuities work?” or, even more basically, “What is an annuity?” So, let’s cover some annuity basics first.
What Is an Annuity?
An annuity is a contract between you (the insured) and an insurance company. They’re used to help you plan for your retirement, and you fund it with your own money. Also, as with the more familiar 401(k) plans for retirement, an annuity grows tax-deferred, so you aren’t responsible for paying taxes on it until you use it.
Unlike a 401(k), though, you get the benefit of guaranteed income with an annuity once it’s fully funded. There are different types of annuities, each of which gets financed differently. For example, you might pay a single lump sum, or you might have regular premium payments so that your annuity is funded over time.
Once an annuity reaches maturity, you can start systematically withdrawing money. That means you can set it up to pay you for the rest of your life or a specific amount of time. Additionally, you can purchase a variety of contract provisions, known as riders, to customize your contract further.
How Do Annuities Work?
As previously mentioned, an annuity isn’t an investment type. Instead, it is a contract type. It works by transferring risk from the annuitant to an insurance company. Note that the owner of an annuity can be different from the annuitant. For example, you can purchase an annuity for your spouse. In this case, you’d be the owner, but your spouse would be the annuitant.
Similar to other insurance products, you pay the insurance company premiums to carry this risk. This premium-paying period is the accumulation phase. Still, unlike health insurance, you don’t pay annuity premiums indefinitely.
Eventually, you cease paying the annuity, and it begins to pay you. When your annuity starts payments, it enters the payout or annuitization phase. These annuity payments can be monthly, quarterly, annual or even a lump sum payment. Additionally, they can begin immediately or be postponed for years or even decades.
Types of Annuities
There are several different types of annuities, and each kind carries distinct features that differentiate them from each other. In this article, we’ll focus on the two primary types: fixed vs variable annuities. Furthermore, there are two different fixed annuities types – immediate and deferred. We’ll explore all of these below.
How does a fixed annuity work? It allows you, the owner, to lock in a rate of earning that’s unaffected by the peaks and valleys of the market. Both the principal investment and a specified interest are guaranteed. So, you receive periodic payments in the amounts defined in your contract. For example, if you’ve purchased a $100,000 fixed annuity with a 5% payout, you’ll receive $5,000 a year.
Key features of fixed annuities include:
- Tax-deferred status — allows you to benefit from compounded growth.
- Minimal-risk exposure — limits your risk to market fluctuations with the opportunity for your money to grow at a guaranteed interest rate.
- Lower investment minimums — usually require an initial investment of $1,000–$10,000.
Immediate Fixed-Income Annuities
Immediate annuities require the owner to pay a lump sum. Then, you receive a guaranteed income stream of income for a specific period — up to a lifetime. Typically, payments begin immediately.
Deferred Fixed-Income Annuities
Under a deferred annuity, you defer your income stream. Instead of starting right away, your income stream kicks in anywhere from months to years after you purchase your annuity. Additionally, you may make extra payments during the deferral period to increase your future annuity income, depending on your contract.
As opposed to fixed annuities, variable annuities have payout rates that vary. These rates are tied directly to the performance of traditional investments in the portfolio. Essentially, the amount you receive depends on how much money this portfolio gains or loses throughout the year.
Therefore, a variable annuity gives you the opportunity for either higher or lower payments. The amount of your payments depends on the performance of the market and your specific investments. So, these variable contracts are subject to investment risk, including the possible loss of your principal amount.
Key features of variable annuities include:
- Tax-deferred growth potential in the accumulation phase — allows you to benefit from compounded growth.
- Death benefit — pays your beneficiaries, or designated charities, if you die before you’ve been fully paid.
- Tax-free and penalty-free transfers for underlying investment options.
What Are Contract Riders?
Contract riders are additional benefits you can attach to your annuity. There are two primary riders: living riders and death benefit riders. Living riders provide benefits while the annuitant is alive. Conversely, death benefit riders pay your estate or beneficiary the difference if you die before your annuity has returned all your premium payments.
Is an Annuity Right for You?
Like any contract, you want to make sure what you’re signing makes sense for you and your family. Some things you should consider before purchasing an annuity include how much money you’ve already saved, the amount of Social Security you expect to receive and how much longer you expect to live.
If you’ll have enough money from Social Security and your other retirement assets, you may not need an annuity. Still, if you’re healthy and want a guaranteed income stream you won’t outlive, you may benefit from an annuity. Ultimately, purchasing an annuity is a highly personal decision you should make only after discussing it with your family and financial advisor.