How Do Annuities Work?

One of the biggest fears people have about retirement is outliving their savings. However, there is a way to plan financially for this so-called longevity risk: an annuity, which can provide guaranteed income for the rest of your life. Here’s how annuities work.

How do annuities work?

An annuity is basically a contract between you and an insurance company.

Annuities come in two basic versions: deferred annuities and income annuities. Both annuity types help to add some certainty to your financial planning and generally come with guarantees that you won’t get with market investments. Whether you’re in retirement or still saving for retirement, an annuity may take a little risk out of your long-term financial plan.

Deferred annuities

How deferred annuities work

Deferred annuities have two phases: the growth period, known as accumulation, and the payment period, often referred to as the annuitization phase.

There are two types of deferred annuities – variable and fixed. Deferred, fixed annuities accumulate value based on a fixed interest rate. In a deferred variable annuity, your premium payment is invested in one or more sub-accounts, which are investment funds for you to choose from. The annuity value is determined by the performance of those subaccounts.

For those looking for potentially higher returns and willing to accept higher risk, a deferred variable annuity might be appropriate. The rate of return varies based on the investments that you choose. Variable annuities typically offer numerous investment options, can help diversify a retirement portfolio, and can be allocated according to your risk tolerance level. The performance of variable funds is not guaranteed and can fluctuate, and there is the risk that you may lose money. Deferred variable annuities also offer a death benefit.

An indexed annuity has features similar to a variable annuity. Rather than choosing investments, your returns are hinged to an equity-based index, such as the S&P 500.  However, how that index is tracked depends on the methods used by the insurance company. Also, different companies may cap the amount of interest you can earn in an indexed annuity or put in a floor to limit potential losses.

Pay attention to

For all annuities, distributions may be subject to ordinary income tax. You’ll also want to pay attention to fee structures, withdrawal (surrender charges) and in most cases, you’ll be charged a 10 percent penalty if you withdraw money from your annuity before reaching age 59-1/2.

Who might benefit from a deferred annuity?

Younger savers who are maxing out their contributions to other retirement accounts and want to continue building and growing their tax-deferred nest egg.  

Income annuities

How an income annuity works

An income annuity is designed to pay out a guaranteed income. There are immediate income annuities that provide an income stream typically starting within 12 months, and there are deferred income annuities where the start date of the income stream can be deferred up to several decades. Income annuities are typically purchased with a lump-sum payment; however, some income annuities also allow for additional premium deposits.  

If you go with an income annuity option, your periodic payments will never change. They will typically be invested in the insurance company’s general fund

Pay attention to

One of the big concerns people have when buying an annuity is that the insurance company will keep all their money if they die right away.

Income annuities have no cash value. Once issued, this annuity cannot be terminated (surrendered), and the premium paid for the annuity is not refundable and cannot be withdrawn.  As with deferred annuities, a 10 percent IRS penalty may apply if distributions are taken before age 59 ½ and distributions may be subject to ordinary income tax. 

Who might benefit from an income annuity?

Risk-averse retirees, or people very close to retirement, who want to convert a lump sum of cash (perhaps a portion of money that you have invested over your lifetime) into a guaranteed stream of income for the rest of their lives, or for a specified timeframe.

If you’re in retirement, saving and compounding growth likely take a backseat to a focus on generating reliable, predictable income. For a retiree, an income annuity could be an effective tool to hedge the risk of outliving your savings, and ensure you’ll always have some money coming in the door throughout retirement.

A final consideration about annuities

You should also consider the financial strength of the company you purchase the annuity from. An annuity is only as good as the company’s ability to guarantee its financial commitment to you. You want to buy an annuity from a company that has an excellent financial strength rating and one that will be around for many more years.  

If you’re interested in learning more about how an annuity might fit into your overall financial plan, a financial pro can discuss what the best options are for you.

No investment strategy can guarantee a profit or protect against a loss. All investments carry some level of risk including the potential loss of all money invested.

Guarantees backed solely by the claims-paying ability of the insurer.