How Annuity Works: A Must-Read Guide

What You Should Know About Annuity

In this article, we'll provide an overview of annuities, breaking down their definition, mechanics, and various types.

What is an annuity?

An annuity is a contract between you and an insurance company in which you make payments over time in exchange for a guaranteed income stream later in life. Annuities can be used for various purposes, such as supplementing your retirement income or providing financial security for your loved ones during your death.

What is a fixed annuity?

A fixed annuity is an annuity that pays a guaranteed rate of return. This means that the policyholder will receive a specific amount of money each month, no matter how the stock market performs. Fixed annuities are a good option for people who want a safe and reliable income stream.

How does an indexed annuity differ from a fixed annuity?

An indexed annuity is an annuity that tracks the performance of a market index, such as the S&P 500. This means that the policyholder's payments will vary based on the performance of the index. Index annuities offer the potential for higher returns than fixed annuities, but they also come with more risk.

Here is a table summarizing the key differences between fixed and indexed annuity:  

Feature Fixed Annuity Indexed Annuity
Return Guaranteed rate of return Participation in market index performance, capped and downside-protected
Risk Lower risk Higher risk
Growth Potential Limited Higher potential for growth
Interest Accrual Fixed interest rate applied each year Interest credited based on index performance
Guarantees Principal protection, guaranteed minimum interest rate Principal protection, guaranteed minimum interest rate, participation in index performance up to a cap, downside protection
Tax Implications Tax-deferred growth Tax-deferred growth
Flexibility Low withdrawal penalties More flexibility with withdrawals, subject to surrender charges
Suitability Those seeking guaranteed income and low risk Those seeking potential for higher returns with downside protection

 

Example of an Annuity

Life insurance policies are an example of fixed annuities, characterized by the fact that the policy owner must pay a fixed amount every month for a specified period (typically 59.5 years) in exchange for a fixed income.

In an annuity, an individual pays a single premium, for example, $200,000, to an insurance company. In return, the individual receives monthly payments, for instance, $5,000, for a certain period. Interest rates and market conditions determine how much immediate annuities will pay out.

A retirement plan that involves annuities can be beneficial, but annuities are complicated financial products. The complexity of these investments means that most employers do not offer them to employees as part of their retirement plans.

Earlier in December 2019, President Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act into law, which loosens rules for employers to select annuities and includes annuity plans in 401(k) and 403(b) plans. The easing of these rules may make more annuity options available to qualified employees in the near future.

How does annuity work?

In essence, annuities convert lump-sum premiums into an impossible income to outlive. It is easier for retirees to meet their daily needs by relying on Social Security and investment savings.

Annuities can provide this income by accumulating and annuitizing or by immediate annuities, which start providing lifetime payments within a month of purchase without requiring accumulation.

The insurance company charges you a premium when you purchase a deferred annuity. Your initial investment will grow tax-deferred during the accumulation phase, typically over ten to thirty years. Once the annuitization, or distribution, phase begins — again, based on the terms of your annuity contract — you will start receiving regular payments.

The insurance company assumes all the risks of a down market in annuity contracts. The annuity owner is therefore protected from market risk and longevity risk, i.e. the possibility of outliving the money in the annuity.

Insurance companies charge fees for managing investments, contract riders, and other administrative services to offset this risk. The surrender charge on annuity contracts can also be incurred during surrender periods when no money can be withdrawn. Additionally, your return may be reduced by spreads, caps, and participation rates imposed by insurance companies on indexed annuities.

Types of annuities

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An annuity's payment period can be structured based on several details and factors. These include the duration of time that payments are guaranteed to continue. In addition to the payment mechanisms mentioned above, annuities can be designed to allow payments to continue for the duration of either the annuitant's life or their spouse's life if a survivorship benefit is chosen. Additionally, annuities can be structured to pay out funds for a specified period, like 20 years, regardless of whether they live to see the end of it.

Immediate and Deferred Annuities

A lump sum deposit can begin annuity benefits immediately, or a deferred benefit can be created. In an immediate annuity, payments begin as soon as the annuitant deposits a lump sum. Annuities that pay out deferred income do not start paying out as soon as the investment is made. It is up to the client to specify an age at which they wish to begin receiving insurance payments.

Annuities may provide some opportunity to recover some of your principal investment, depending on the type you select. A beneficiary who receives a straight lifetime payment does not receive a refund of the principal. The payments continue until the beneficiary dies. A fixed-term annuity may give the recipient a refund of the remaining principal or the heirs if the annuitant passes.

Fixed and variable annuities

Generally, annuities are either fixed or variable.

  • In a fixed indexed annuity, the annuitant receives regular periodic payments.
  • Variable annuities allow the owner to receive larger future annuity payments if the investment fund does well and smaller payments if the investment fund performs poorly. In this case, the annuitant receives less stable cash flow than a fixed annuity but has access to many of the fund's investments and benefits.

There is some market risk associated with variable annuities and the potential for principal loss; however, riders and features can be added at an additional cost. In this way, they can be considered hybrid fixed-variable annuities. Consequently, contract owners earn upside portfolio potential while being assured that their portfolio won't lose value due to lifetime minimum withdrawal benefits.

Death benefits or acceleration of payouts can be added to annuities if the annuity holder diagnoses with a terminal illness. Cost-of-living riders adjust the cash flows for inflation by adjusting them for changes in the consumer price index (CPI).

Advantages of annuities

issuing insurance company

A key advantage of annuities is that they enable the investor to accumulate money without paying interest taxes. The contribution limit on annuities is not the same as that on 401(k)s and IRAs.

Another advantage of annuities is that they provide a predictable income stream for retirement. Annuities guarantee that you will keep your savings. It is a major advantage for those who are post-pension.Your lifestyle and financial situation should determine why you invest in an annuity.

Tax-Deferred Growth: One of the critical benefits of an annuity is that it allows the investor to save money without paying taxes on the interest until a later date.

No Contribution Limits: Annuities have no contribution limits, unlike 401(k)s and IRAs.

Predictable Income Stream: Another significant benefit of annuities is the creation of a predictable income stream to fund retirement. With an annuity, you don't have to worry about outliving your savings.

Fund Your Retirement: An annuity can provide a safe and secure way to invest for retirement. If you are worried about outliving your retirement savings, an annuity can give you the peace of mind of knowing that you will have a stream of income for life.

Provide for Your Family: An annuity can also be a financial tool to help care for your family after you die.

Complex Investments: Annuities can be complex investment vehicles. Anyone considering investing in an annuity should consult a financial advisor to ensure it is right for their unique financial needs.

Disadvantages of annuities

A consumer may consider it a disadvantage to sacrifice liquidity for lifetime financial security. An annuity may not be a good choice depending on your financial situation, short-term or financial goals. When you don't find a valuable and viable product, it makes no sense to purchase it.

There are also several common concerns regarding annuities' structure and design, including:

  • Complexity
  • Commissions and fees
  • Loss of potential returns from other investments
  • Investment products offer conservative returns

People commonly cite opportunity cost as a drawback. It refers to the loss of potential returns. These investment objectives are valid for people with higher risk tolerance.

An aggressive investment strategy benefits younger investors with longer time horizons since they have time to grow their money and can bounce back if the market declines temporarily.

Retirees and older investors need to consider the opportunity costs associated with their specific situations. Annuities are unlikely to be considered a disadvantage by people in this age group due to opportunity costs.

How Are Annuities Taxed?

Many financial professionals recommend tax-deferred growth potential annuities to their clients. Your investment will grow tax-free if you maintain a contract with the annuity provider. Income payments from the annuity will be taxed once they mature.

Annuity payouts are taxed differently depending on the type. You will be taxed on the withdrawal amount if you own a qualified annuity. In contrast, withdrawals from non-qualified annuities are only taxed on earnings.

Annuity riders & annuity Fees

You can purchase annuity riders when you sign up for an annuity. You may add these benefits to your contract for an additional fee. These are some of the most common riders:

Lifetime income rider. 

You may run out of money if your investments grow slowly enough after you start collecting payments from a variable annuity. You can expect your monthly payments to continue even if your account balance runs out.

COLA rider. 

If you add this rider, your annuity payments will increase with inflation and the cost of living. It's up to you how much growth you want in your monthly payments.

Impaired risk. 

Your life expectancy could be shortened if you suffer from a severe illness, resulting in fewer payments and less income if you collect an annuity. When you become seriously ill, the size of your annuity payment increases. This is so that you receive more money sooner to make up for the short life expectancy you may have.

Death benefit rider. 

Depending on when you die, you may receive less than you paid into an annuity. If you have a return of the premium rider, your heirs will receive money from the annuity company. For example, premium riders' return ensures they get at least as much as you paid for the contract. For instance, if you paid $300,000 but received only $200,000, your heirs would receive a check for $100,000.

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Is an annuity a good investment?

Your investment needs and goals must be considered when determining whether an annuity is good. Your age, risk tolerance, and lifestyle should also be considered.

A young person is generally more able to tolerate risk. In this case, you should invest in products with higher growth potential. Although annuities are usually not as lucrative as stocks or other investments, they provide guaranteed growth over a long period.

Retirement consumers tend to invest in annuities as an excellent way to prepare for retirement. The modest returns annuities offer offset by their tax-deferred growth and principal protection. The benefit of annuities over other retirement solutions is that they provide a stream of income that can't be outlived.

When considering whether an annuity is a good savings vehicle, consider which features are most important. The right annuity investment might be right for you if you're looking for a safe investment that grows tax-deferred and can be passed down to your beneficiaries.

What is better than an annuity for retirement?

There is no one-size-fits-all answer to this question, as the best retirement savings option for an individual will depend on their specific circumstances. However, there are several other types of retirement savings vehicles that can be a good alternative to annuities, such as traditional IRAs, Roth IRAs, and 401(k)s. These options offer more flexibility and control over your retirement savings, and they may also offer the potential for higher returns.

Here is a table that summarizes the key differences between annuities and other retirement savings options:

Feature Annuities Traditional IRAs Roth IRAs 401(k)s
Insurance protection Yes No No No
Guaranteed income Yes (fixed annuities) No No No
Tax treatment Earnings taxed as ordinary income Earnings taxed upon withdrawal Earnings taxed upfront, tax-free withdrawals Earnings taxed only on withdrawals
Flexibility Low High High Medium
Control Low High High Medium

Frequently Asked Questions

  • An annuity is a financial product that provides a regular stream of payments to the policyholder. Annuities are typically used as a retirement income solution, but they can also be used for other purposes, such as funding college education or providing long-term care.
  • An income annuity is an annuity that provides the policyholder with a stream of payments that lasts for a specific period of time, such as a lifetime or 10 years. Income annuities are a good option for people who want to ensure that they have a steady income stream for a certain period of time.
  • A non-qualified annuity is an annuity that is not purchased with pre-tax money. This means that the policyholder will pay taxes on the earnings from the annuity each year, even before they start receiving payments. Non-qualified annuities are a good option for people who want to use their own money to save for retirement.
  • A deferred annuity is a type of insurance contract that offers a guaranteed income payout at a future date. The policyholder makes contributions to the annuity over time, and the insurance company invests these funds. The policyholder will then receive a stream of payments, either for a fixed period of time or for the rest of their life.
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Rinaily Bonifacio

Written by:

Rinaily Bonifacio

Rinaily is a renowned expert in the field of human resources with years of industry experience. With a passion for writing high-quality HR content, Rinaily brings a unique perspective to the challenges and opportunities of the modern workplace. As an experienced HR professional and content writer, She has contributed to leading publications in the field of HR.

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