Guide to Annuities: What They Are, Types & How They Work?

Annuities

Overview

What Is an Annuity?

An annuity is a contract offered by financial institutions and purchased by individuals. It guarantees the issuer will pay out a fixed or variable income stream to the purchaser, either immediately or at a later date.

People buy annuities by making monthly premium payments or a lump-sum payment. The issuing institution then provides a series of payments for a set period or for the rest of the annuitant’s life.

Annuities are primarily used for retirement income. They help individuals manage the risk of running out of savings during retirement.

Key Facts

  • Annuities are financial products that provide a guaranteed income stream and are typically purchased by retirees.
  • The accumulation phase is the initial stage of an annuity, where investors fund the product with either a lump-sum payment or periodic payments.
  • After the annuitization period, the annuitant starts receiving payments for a fixed period or for their lifetime.
  • Annuities offer flexibility as they can be structured into various instruments.
  • Annuities can be immediate or deferred, and can be fixed, variable or indexed.

How an Annuity Works?

Purpose

Annuities work by providing a steady income stream to people during their retirement, ensuring they don’t run out of money. To achieve this, some investors may buy an annuity contract from an insurance company or financial institution.

These products are suitable for investors, known as annuitants, who seek stable, guaranteed retirement income. However, they may not be suitable for younger individuals or those needing liquidity, as the invested cash is less accessible and may incur withdrawal penalties.

Phases

An annuity goes through several phases, including:

  • The accumulation phase: This is when the annuity is being funded and payouts have not yet started. The money invested in the annuity grows tax-deferred during this period.
  • The annuitization phase: This is when the payouts to the invest or begin.

Immediate vs Deferred

Annuities can be immediate or deferred:

  • Immediate annuities are typically bought by individuals who have received a large sum of money, like a settlement or lottery win and want to convert it into future cash flows.
  • Deferred annuities, on the other hand, are designed to grow tax-deferred and offer guaranteed income starting on a date chosen by the annuitant.

Regulation

Variable annuities fall under the regulation of the Securities and Exchange Commission (SEC) and state insurance commissioners. Fixed annuities, however, are not considered securities and are therefore regulated solely by state insurance commissioners.

Indexed annuities are usually regulated by state insurance commissioners. If they are classified as securities, they are also regulated by the SEC. The Financial Industry Regulatory Authority (FINRA) oversees variable and registered indexed annuities.

Agents or brokers selling annuities must have a state-issued life insurance license. For variable annuities, they also need a securities license. These agents or brokers typically earn a commission based on the annuity contract’s notional value.

FYI: Annuities frequently come with complex tax implications, so it’s critical to understand how they function. Before purchasing an annuity contract, consult with a professional, just like you would with any other financial product.”

Other Considerations

Surrender Period & Withdrawals

  • Annuities often have a surrender period, during which annuitants cannot withdraw money without paying a fee. This period can last for several years.
  • It’s important for investors to consider their financial needs during this time. For example, if there’s a major event like a wedding that requires a large sum of money, they should assess if they can afford to make annuity payments.
  • Many insurance companies allow annuitants to withdraw up to 10% of their account value without a fee. But withdrawing more than that may incur a penalty, even after the surrender period has ended. There are also tax implications for withdrawals before age 59½.
  • Some annuitants facing financial difficulties may choose to sell their annuity payments. This is similar to borrowing against any other income stream: They receive a lump sum in exchange for giving up some or all of their future annuity payments.

Income Rider

An annuity contract often includes an income rider, which guarantees a fixed income once the annuity starts paying out. When considering an income rider, investors should ask:

  1. When will they need the income? The payment terms and interest rates may vary based on the annuity’s duration.
  2. What are the fees associated with the income rider? While some organizations offer it for free, most charge fees for this service.

Investing in annuities ensures individuals won’t outlive their income, reducing longevity risk. It’s important for purchasers to understand that by investing in an annuity, they are trading a liquid lump sum for a guaranteed series of cash flows.

Some purchasers may hope to profit by cashing out an annuity in the future. However, this is not the intended use of the product.

Fact: Lifetime guaranteed annuities, such as defined benefit pensions and Social Security, provide retirees with a consistent cash flow until their death.”

Annuities in Workplace Retirement Plans

Annuities can be a valuable component of a retirement plan, but they are complex financial products. Due to this complexity, many employers do not offer them as part of their employees’ retirement portfolios.

However, the SECURE Act, signed into law by President Donald Trump in 2019, has relaxed the rules on how employers can select annuity providers. This includes allowing annuity options within 401(k) or 403(b) investment plans.

These rule changes may lead to more qualified employees investing in annuities as part of their retirement planning.

Annuities Types

Annuities come in various forms, including how long payments are guaranteed to continue:

Annuities Types

  • Some annuities make payments as long as the annuitant is alive or their spouse if a survivorship benefit is chosen.
  • Others pay out for a fixed period, like 20 years, regardless of how long the annuitant lives.

Immediate & Deferred Annuities

Annuities can start paying out immediately after a lump sum is deposited, or they can be set up for deferred benefits.

Immediate payment annuities start paying as soon as the annuitant deposits a lump sum. Deferred income annuities, however, don’t start paying until a later age specified by the client.

Depending on the type of annuity chosen, it may or may not be possible to recover some of the principal invested. With a straight lifetime payout, there is no refund of the principal; payments continue until the beneficiary passes away.

If the annuity is set for a fixed period, the recipient may receive a refund of any remaining principal, or it may go to their heirs if the annuitant dies before the period ends.

Fixed, Variable & Indexed Annuities

Annuities come in three main types: fixed, variable and indexed:

  • Fixed annuities offer a guaranteed minimum interest rate and fixed periodic payments.
  • Variable annuities allow for larger future payments if the annuity fund performs well, but smaller payments if it performs poorly. This means the cash flow is less stable compared to fixed annuities, but it allows the annuitant to benefit from strong investment returns.
  • Indexed annuities are fixed annuities that provide a return based on the performance of an equity index, like the S&P 500.

Variable annuities carry market risk and the potential to lose principal, but additional riders and features can be added to them for an extra cost. These can include guaranteed lifetime minimum withdrawal benefits, death benefits or adjustments for inflation based on the consumer price index.

Criticism of Annuities

One criticism of annuities is their lack of liquidity. When you deposit money into an annuity contract, it’s typically locked up for a specific period, known as the surrender period. If you withdraw any or all of the money during this time, you may incur a penalty.

Surrender periods can range from two to more than 10 years, depending on the specific annuity product. The penalty for early withdrawal can be significant, starting at 10% or more and decreasing annually over the surrender period.

Another criticism is the complexity and cost of annuities. Sometimes, individuals purchase annuities without fully understanding how they work or the associated costs. It’s important to research and understand all fees, charges, expenses, and potential penalties before investing in an annuity.

Life Insurance vs Annuities

Life Insurance vs Annuities

Life Insurance

Life insurance and annuities are offered by two main types of financial institutions: life insurance companies and investment companies.

For life insurance companies, annuities serve as a natural hedge for their insurance products. Life insurance covers the risk of premature death, where policyholders pay premiums for a lump sum payout upon their death.

If a policyholder dies prematurely, the insurer pays out the death benefit at a loss. However, through actuarial science and claims experience, insurers price their policies so that, on average, policyholders live long enough for the insurer to earn a profit.

In many cases, the cash value inside permanent life insurance policies can be exchanged for an annuity product without any tax implications.

Annuities

Annuities, on the other hand, address longevity risk, or the risk of outliving one’s assets. The risk for the issuer is that annuity holders will live longer than expected, outlasting their initial investment.

To manage this risk, annuity issuers may sell annuities to customers with a higher risk of premature death.

Examples of an Annuity

  • A fixed annuity can be likened to a life insurance policy, where an individual pays a fixed amount each month for a set period (usually until they reach 59.5 years old) and receives a fixed income stream during retirement.
  • An immediate annuity involves a single premium payment, such as $200,000, to an insurance company. In return, the individual receives regular payments immediately, like $5,000 per month, for a fixed period. The payout amount for immediate annuities depends on market conditions and interest rates.

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FAQs

Who Buys Annuities?

Annuities are suitable for individuals seeking stable, guaranteed retirement income. However, they are not recommended for younger individuals or those needing liquidity, as the money in an annuity is less accessible and may incur withdrawal penalties. Annuity holders are protected from outliving their income stream, which helps manage longevity risk.

What Is a Non-Qualified Annuity?

Annuities can be purchased with pre-tax or after-tax dollars. A non-qualified annuity is bought with after-tax dollars, while a qualified annuity is bought with pre-tax dollars. Qualified plans include 401(k) and 403(b) plans. Only the earnings (not the contributions) of a non-qualified annuity are taxed upon withdrawal, as they are funded with after-tax money.

What Is an Annuity Fund?

An annuity fund is an investment portfolio where an annuity holder’s payments are invested. It can include stocks, bonds, and other securities. The returns earned by the annuity fund determine the payout received by the annuity holder.

What Is the Surrender Period?

The surrender period is the duration an investor must wait before withdrawing funds from an annuity without facing a penalty. Withdrawing before this period ends can result in a surrender charge, which is essentially a deferred sales fee. Surrender periods typically last several years.

Final Bite

An annuity is a financial agreement between an individual and an insurance company. The individual can make a lump sum payment or regular payments over time. In exchange, the insurance company provides regular payments to the individual, starting either immediately or at a future date.

Annuities can be classified as fixed, variable, or indexed. Fixed annuities offer a set payment amount, variable annuities’ payments vary based on the performance of the investments, and indexed annuities’ returns are linked to an equity index like the S&P 500.

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