What is an Annuity and How Does it Work?

Worried about running out of money in retirement? You’re not the only one. A 2019 survey from Aegon and Transamerica Center for Retirement Studies indicates that 40% of people globally are worried about outliving their savings

Annuities are attractive because they address that concern. Savings accounts run dry eventually, but an annuity can pay out income to you for the rest of your life. While that sounds like the holy grail of retirement planning, annuities aren’t without drawbacks. For one, they’re complicated. And, those who sell annuities may not be great at explaining the nuances or even the basic options. For that reason, it’s useful to have a baseline understanding of how annuities work before you start shopping for one. 

 

Annuity definition 

What is an annuity? An annuity is a customizable contract between you and an insurance company. Under that contract, you pay a premium to the insurer, either at once or over time. In exchange, the insurer pays out a series of payments to you, for a stated timeframe or for your lifetime. Those payments can begin immediately or at some future date. 

 

Annuity income 

What is annuity income? Annuity income is the stream of payments you receive from your annuity contract. Unfortunately, there’s no easy formula to explain how your annuity investment — the premium — is converted into an income stream. The amount you’ll receive in annuity income is dependent on many factors, including the duration of the payments and type of annuity. While annuities are best known for providing a lifetime stream of payments, you can also structure one to pay out over a specific period of time, such as 10 years.  

Lifetime income has a trade-off 

An annuity that’s guaranteed to pay you monthly for the rest of your life can quiet your solvency concerns. But as you might expect, there’s a cost trade-off for that peace of mind. You’re likely to get less for your premium on a lifetime annuity vs. a fixed-duration annuity. If you think about the future value of annuity formula, this makes sense. Mathematically, the insurer needs to know how long it must make payments to you to figure its costs. But the number of payments required under the contract is tied to your lifespan, which is unknown. There is the chance you could outlive your life expectancy by a long shot. Generally speaking, insurance companies address unknowns and uncertainties with higher premiums.

Ultimately, the choice between lifetime income and fixed-duration income boils down to what you’re willing to pay for peace of mind. If you’re not sure which option suits you best, ask your advisor to estimate both.

 

How annuities work 

How do annuities work, exactly? The answer depends on the type of annuity. At the most basic level, annuities can be immediate or deferred. Additionally, deferred annuities can be fixed, indexed, or variable annuities. 

An immediate annuity, also known as single-premium immediate annuity, is purchased with one lump-sum payment; in return, your income stream starts within 30 days. You’d be interested in an immediate annuity if you have a large sum of cash on hand, you’re concerned about preserving the value of that cash, and you could use the extra income now. Purchasing the annuity would be an alternative to keeping those funds in cash savings account, where they’d earn minimal returns, or investing in the stock market, where you risk loss of value. 

A deferred annuity delays the start of the income stream until some future date. Your premiums can be paid in one payment or in a series of payments. The time between initiation of the annuity and the start of the income stream is called the accumulation phase. During the accumulation phase, your annuity is earning tax-deferred interest. That growth allows you to build a larger income stream later. Normally, that interest gets rolled into your income once the payout phase begins. But you may have the option to withdraw the interest during the accumulation phase

The rate at which a deferred annuity earns interest depends on whether the annuity is fixed, indexed, or variable.

Deferred fixed annuity 

A fixed annuity earns interest at a guaranteed rate for a specified term, usually two to 10 years. After the initial term ends, the insurer sets a new rate for the renewal term. Your annuity contract will specify a minimum interest rate allowed for the life of the annuity, and your renewal rate cannot be below that minimum. 

Interest rates on fixed annuities are usually slightly higher than what you’d earn by keeping your money in a certificate of deposit or CD. You can get higher rates on annuity contracts with shorter terms, while contracts with longer terms will have lower rates.  

Deferred indexed annuity 

An indexed annuity accumulates value in lockstep with a stock market index, such as the S&P 500. That structure opens the door for you to earn higher returns than what’s available in a fixed annuity. Your indexed annuity contract should also have some mechanism to limit your losses during down markets. For example, your insurer might offer you a minimum rate of 2% on 90% of your premiums paid. That minimum would only kick in when the performance of the underlying index falls below that minimum. 

Deferred variable annuity 

A variable annuity is invested in diversified funds, called sub-accounts. These funds work like mutual funds, in that each fund has a specific investment strategy. Your annuity would then grow — or shrink — based on the total performance of those funds. 

The variable model is similar to stock market investing. You have the opportunity for upside, which will mean higher annuity payments later. But your underlying funds can also lose value, which would lower your annuity income. You’d manage that risk by diversifying your fund selections across asset classes, industry segments, and even currencies.

 

Annuities pros and cons 

Annuities are popular with healthy individuals with high net worth who want to diversify their retirement income. Here are the pros and cons.

Advantages of annuities 

  • Tax-deferred growth: A deferred annuity earns interest on a tax-deferred basis. Much like a 401(k) or traditional IRA, the withdrawals or distributions you take from your annuity are taxed as regular income. Unlike a tax-advantaged retirement plan, you do not get a tax deduction for your annuity premiums.
  • Capital preservation: You can lose money on a variable annuity, but you will not lose value on fixed or indexed annuities.
  • No contribution limits: 401(k)s and IRAs are subject to annual contribution limits, which cap your access to tax-deferred earnings in these accounts. If you have the resources to exceed contribution limits in your retirement accounts, an annuity can be an attractive supplement. Otherwise, the saver would probably hold those funds in a bank or brokerage account, where all dividends and interest would be taxable in the current tax year.
  • Reliable income: An annuity provides reliable income. The insurer is contractually obligated to make your annuity payments in accordance with the terms of your contract. The biggest risk you face is that the insurer will go out of business or otherwise be unable to satisfy the contract. You can mitigate that risk by working only with insurers in good financial standing.
  • Customizable. There are many ways to customize your annuity. You can add a death benefit rider, for example, to transfer leftover annuity funds to your family when you die. You could also add inflation protection with cost of living adjustments, which keeps your income stream from losing purchasing power over time.

Disadvantages of annuities 

  • Complexity: Annuities are complex. There’s no easy formula to understand how your premiums translate into income. That makes it difficult to compare an annuity to other ways you can deploy or invest your money.
  • High fees: Most annuities have built-in fees for administration, fund management, cash withdrawals, etc. These fees do reduce the return you earn on your premiums.
  • Lower returns vs. other investment types: If you were to evaluate annuities as investments, the returns are lower than what you’d earn over the long-term in the stock market. Even variable annuities, which have more upside, will earn less than index-fund investing, because of the fees.
  • Reduced liquidity: There are restrictions on accessing the cash in your annuity. If you pull money out before the age of 59 and a half, you’ll pay income taxes on the withdrawal, plus a 10% penalty. Your annuity provider may assess fees on withdrawals, too. For example, you’ll be subject to surrender charges for taking money out too early. And, your contract might impose caps on withdrawals, either in dollar amount or frequency. Exceed those caps and you can expect to pay a fee.
  • Uncertain returns: If your annuity has no death benefit, there is the risk that you’ll die sooner than expected. In that case, your payments could end long before you’ve gotten your money’s worth. 

Is an annuity right for you?

A properly structured annuity will guarantee your solvency for as long as you live, but it’s not a suitable solution for everyone. Talk with a trusted financial advisor to understand how an annuity fits into your retirement and estate plans.


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