BlogStructured SettlementWhat is An Annuity, And How Does It Work?

What is An Annuity, And How Does It Work?

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An annuity is a financial product that provides a fixed or variable income stream during retirement. Annuities have become increasingly popular as more Americans reach retirement age. However, annuities can also seem complex and confusing.

This comprehensive guide will explain exactly what an annuity is, how annuities work, the pros and cons, and the major types of annuities available. Read on to fully understand annuities and determine if one might be right for your retirement needs.

What is An Annuity?

An annuity is essentially a contract between you and an insurance company. With an annuity, you make either a lump-sum payment or a series of payments to the insurer. In return, they provide you with a regular income stream now or in the future.

Annuities are most commonly used to provide a steady income during retirement. However, they can also be used to supplement retirement savings or provide for a surviving spouse. Annuities are often referred to as an alternative to pensions.

There are three key parties in an annuity contract:

  • Contract Owner – The person purchasing the annuity.
  • Annuitant – The person receiving the benefits of the annuity. This is usually the contract owner unless otherwise specified.
  • Beneficiary – The person who receives any remaining annuity benefits after the annuitant’s death.

Annuities have two main phases:

  • Accumulation Phase – The period when you make payments into the annuity and earnings accumulate on a tax-deferred basis. This phase lasts until you begin taking income payments.
  • Payout Phase – The period when you begin receiving regular income payments from the annuity. This can be for life, for a fixed period, or a combination.

In addition, most annuities offer a death benefit, which provides a payment to your beneficiary if you pass away during the accumulation or payout phases.

How Do Annuities Work?

In simplest terms, you give an insurance company money now in return for them paying you at a later date. Here is a high-level overview of how annuities work:

  1. You either pay a lump sum or make periodic payments to the insurance company to purchase the annuity contract.
  2. The insurer invests your premium payments in its general account or separate accounts.
  3. Your funds grow on a tax-deferred basis until you begin taking payouts.
  4. At some point in the future, often in retirement, you begin receiving regular income payments from the annuity.
  5. You receive income payments for life or a defined period, depending on the type of payout option you select.
  6. When you pass away, any remaining value is paid to your named beneficiaries per the contract terms.

Annuities contain guarantees backed by the financial strength of the issuing insurance company. They use “mortality credits” to help fund income payments based on the expected lifespan of each annuitant.

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In exchange for these features, insurance companies charge various fees and expenses to cover administrative costs, and commissions and to generate shareholder profits. We’ll cover these charges in more detail later.

The Benefits

Annuities offer several potential benefits that make them attractive, especially for retirees:

Guaranteed Income – Annuities can provide guaranteed income for life or for a certain time period. This income is contractually backed by the insurer.

Tax-Deferred Growth – Earnings grow tax-deferred until you make withdrawals, allowing faster accumulation.

Variety of Payout Options – Annuities offer flexible income options, including lifetime income, joint income, period certain, and lump sum payouts.

Death Benefits – Most annuities pay out a death benefit to your beneficiaries if you pass away during the accumulation or payout phases.

Avoid Probate – Assets held within an annuity bypass probate upon the contract owner’s death.

Ability to Convert 401(k) – Many employers allow you to convert your 401(k) balance to an annuity upon retirement.

Lifetime Income Riders – Some annuities offer riders that guarantee minimum lifetime withdrawals, providing protection against market declines.

Nursing Home Waiver – Certain annuities waive surrender charges if you must enter a nursing home or long-term care facility.

In summary, the core benefit of an annuity is providing reliable, consistent income for life or for a defined period of time. This makes them especially useful for funding retirement.

The Drawbacks and Risks

While annuities offer several advantages, they also come with some potential drawbacks to consider:

High Fees – Annuities can impose high administrative fees, commissions, mortality expenses, and investment management fees that erode returns.

Limited Liquidity – It can be difficult and expensive to withdraw funds from an annuity, especially during the first 5-15 years.

Taxation of Gains – Withdrawals are taxed at ordinary income rates rather than lower capital gains rates.

No Participation in Market Gains – Fixed annuities do not participate in stock market gains (variable annuities do).

Inflation Risk – Fixed payments may lose purchasing power over time due to inflation.

Credit Risk – Payment guarantees rely on the financial strength and claims-paying ability of the insurer.

Complexity – Annuity contracts can be complex, difficult to compare, and contain limitations hidden in fine print.

Annuities also aren’t right for everyone. Younger investors may be better off maximizing 401(k) and IRA contributions for now due to the limited liquidity of annuities. Those with adequate pension or retirement assets may not need the extra income assurance.

Carefully weigh the benefits versus the risks based on your individual retirement plans and income needs. Consult a financial advisor if unsure.

The Major Types

There are many different types of annuities available. The two main distinguishing factors are when you start receiving payments and whether returns are fixed or variable:

Immediate vs. Deferred Income

Immediate Annuities – Also known as single premium immediate annuities (SPIAs), these begin paying income within one year of purchasing the contract. They are usually bought with a single lump-sum payment.

Deferred Annuities – These have an accumulation phase where you pay a premium and earnings accumulate tax-deferred. Payouts don’t begin until a later date, usually retirement. Deferred annuities can be funded with either a single or multiple payments.

In other words, immediate annuities start paying out quickly while deferred annuities have an investing period first where your funds grow before payouts.

Fixed vs. Variable

Fixed Annuities – Provide a guaranteed, predictable rate of return by crediting interest at a fixed rate. The insurance company bears the investment risk.

Variable Annuities – Offer investment returns that vary based on the performance of underlying subaccounts, similar to mutual funds. The contract owner bears the investment risk.

Fixed annuities provide stable, reliable income payments, while variable annuities offer the possibility of higher returns tied to the markets. You can also purchase indexed annuities, which blend aspects of fixed and variable together.

Indexed Annuities

Indexed annuities, sometimes referred to as fixed-indexed or equity-indexed annuities, blend aspects of fixed and variable annuities. With an indexed annuity, your funds are deposited with the insurer, and earnings are based on the performance of a market index like the S&P 500.

Upside potential is capped while downside risk is limited, providing some upside without full exposure to market losses. Indexed annuities offer returns linked to indices while providing principal protection – a combination of features from both fixed and variable annuities.

How Do Fixed They Work?

As the name suggests, fixed annuity payouts provide a “fixed” rate of return that is set by the insurance company. Let’s look at how immediate and deferred fixed annuities work:

Immediate Fixed Annuities

  • Purchase contract with a single premium payment
  • Start receiving fixed payments right away (within 12 months)
  • Payments continue for a set period or lifetime
  • Death benefit paid to beneficiary if you pass away first

Deferred Fixed Annuities

  • Make ongoing contributions during the accumulation phase
  • Earnings grow at a fixed interest rate credited by the insurer
  • Take income withdrawals at retirement
  • Receive payments for a specific period or over the lifetime

Fixed annuities are further categorized based on how the interest rate is determined. Some common types include:

  • Multi-Year Guaranteed – Fixed rate locked in for 2 to 10 years
  • Single Premium – Fixed rate guaranteed for one year only
  • Market Value Adjusted – Rate fluctuates with bond market indices

Deferred fixed annuities offer predictable returns while protecting the principal. This makes them appealing to retirees looking for stable income. However, they do carry inflation risk and don’t participate in market gains.

How Do Variable Annuities Work?

As the name implies, variable annuities provide investment returns that vary based on the performance of underlying investments. Here is how they work:

  • Purchase contract with lump-sum or ongoing contributions
  • Choose to invest premiums in subaccounts similar to mutual funds
  • Subaccounts are professionally managed and invest in stocks, bonds, money markets
  • Returns vary based on the performance of subaccounts selected
  • Take income withdrawals during the retirement phase

Variable annuities are considered securities and not insurance products. You assume the investment risk, which means the potential for higher returns, but also the risk of principal loss if the investments decline in value.

Variable annuities may offer guaranteed living benefit riders for an added fee. These provide protection against market downturns to help generate lifetime income.

Common types of living benefit riders include:

  • Guaranteed Minimum Accumulation Benefit (GMAB)
  • Guaranteed Minimum Income Benefit (GMIB)
  • Guaranteed Lifetime Withdrawal Benefits (GLWB)

Carefully read the terms, as there are often limitations and restrictions that apply.

Are They a Good Investment?

Annuities can provide valuable benefits but also have some big drawbacks. The best way to determine if an annuity is right for you is to carefully evaluate your specific financial situation.

These are some of the key factors to consider when deciding if an annuity makes sense:

  • Age – Annuities appeal more to those over age 60, given the illiquidity and growth limitations.
  • Time Horizon – If you have 20+ years until retirement, the liquidity and slow growth of annuities may be prohibitive.
  • Income Needs – Do you anticipate needing supplemental income in retirement beyond Social Security and pensions? If so, an annuity may help fill this “retirement income gap”.
  • Risk Tolerance – Concerned about stock market volatility in retirement? Annuities can provide guaranteed income regardless of what happens in equities.
  • Beneficiary Situation – Do you have a spouse or dependents you want to provide income for beyond your lifetime? Certain annuities pay out through joint lives.
  • Tax Situation – Are you currently paying high-income taxes on 401(k)/IRA required minimum distributions? Non-qualified annuities allow you to defer taxation.
  • Existing Assets – Review current assets and projected retirement income from all sources before deciding if an annuity is needed.

For younger investors, maxing out 401(k) and IRA contributions often makes more sense than locking up assets in an annuity. Annuities also aren’t right for the ultra-wealthy, given limited upside potential.

But for middle-income retirees concerned about funding their golden years, annuities can provide valuable income security and stability.

Who Should Consider Purchasing?

Based on their benefits and drawbacks, annuities may make sense for certain individuals, such as:

  • Those seeking stable, guaranteed income in retirement are not impacted by market volatility. This gives peace of mind.
  • Retirees looking to generate lifetime income to cover essential living expenses through advanced age.
  • People with minimal pensions or other retirement income sources besides Social Security. Annuities can help fill this “retirement income gap.”
  • Individuals with moderate risk tolerance seek modest, fixed returns on a portion of their portfolio.
  • Those who wish to delay RMDs from IRAs/401(k)s and defer the tax hit by using non-qualified annuities funded with after-tax dollars.
  • People who want to eliminate probate costs and delays for beneficiaries by holding assets in an annuity.
  • Retirees who want to simplify their finances by exchanging a 401(k) balance for lifetime income payments.

Annuities come in many shapes and sizes. Work with a financial advisor to see if certain types might be suitable given your retirement objectives.

Who May Not Benefit?

While annuities offer useful benefits to some, they may be inappropriate for others like:

  • Investors under age 50 – Annuities lock up assets and limit liquidity needed to meet other goals. Younger investors are usually better off maximizing 401(k)s and IRAs for now due to the flexibility and growth potential.
  • Individuals with adequate retirement income – If you already have sufficient income from pensions, 401(k) withdrawals, rental income, etc., then an annuity may be overkill. Evaluate your cash flow needs in retirement first.
  • Aggressive investors – People comfortable with equity market risk may prefer investing in stocks, mutual funds, and ETFs. Annuity returns are constrained.
  • Ultra-high net worth – Wealthy individuals may not need or want the extra security of annuity payments given their ample existing assets. The trade-off is limited upside potential.

Always assess your personal financial picture before committing significant sums to an annuity. They aren’t right for everyone. Many find they don’t actually need one.

Are They Safe?

Annuities are generally considered safe when purchased from a financially strong provider. Here are some tips on how to mitigate annuity risks:

  • Only work with highly-rated insurance carriers with a track record of honoring claims. Check independent ratings.
  • Review the product prospectus to understand guarantees, limitations, fees, and the claims-paying ability of the insurer.
  • Don’t put all your assets in annuities. Diversify your portfolio.
  • If pursuing a variable annuity, go with a respected firm and low-cost investment options.
  • Compare multiple annuity quotes to find the best rates and features for your situation.
  • Annuities from providers in your state fall under state guaranty associations offering some protection.
  • The SEC and FINRA regulate annuity sales practices and require disclosure of commissions and fees.

Annuities aren’t FDIC-insured like bank accounts. But purchased wisely from leading insurers, they can provide secure retirement income.

How Do They Compare to Life Insurance?

Annuities share some similarities with life insurance but also have important differences:

Similarities

  • Offered primarily by life insurance companies
  • Utilize mortality credits
  • Allow beneficiary designations
  • Bypass probate

Differences

  • Purpose: Annuities provide income, life insurance provides a death benefit
  • Payouts: Life insurance pays beneficiaries lump sum; annuities pay contract owner
  • Tax Treatment: Life insurance death benefits are tax-free, annuity withdrawals are taxed
  • Fees: Life insurance charges lower fees overall compared to annuities
  • Investments: Annuities invest in securities, life insurance holds conservative instruments
  • Risks: Life insurance is a lower risk given stable returns and lack of market exposure

So in summary, life insurance and annuities are distinct products both offered by insurers to meet different planning needs.

Real-World Example

Let’s look at an example to illustrate how an annuity works.

Meet Sally, a 65-year-old woman getting ready to retire. Sally has $250,000 in retirement savings but is concerned about generating lifetime income since she doesn’t have a pension.

Sally takes $200,000 of her nest egg and purchases a single premium immediate annuity. In return for her lump-sum premium, the annuity provides $1,000 per month in guaranteed income payments for the rest of Sally’s life.

These payments are fixed and predictable. Sally can rely on receiving $1,000 monthly no matter how long she lives or what happens in the markets. The insurance company has contractually guaranteed her income.

Now, say Sally passes away at age 85 (life expectancy is 82). She received $240,000 worth of income payments over the 20 years ($1,000 x 12 months x 20 years). While less than she paid in, Sally gained income security by shifting longevity risk to the insurer.

Without the annuity, Sally would have had to self-manage her retirement funds. She might run out of money if she outlived her life expectancy. The annuity provided lifetime income protection.

This example shows how annuities can provide longevity protection and income security for retirees. Sally effectively exchanged a lump-sum premium for a guaranteed income stream she could never outlive.

Frequently Asked Questions

Still, have questions about how annuities work and if they make sense for your situation. Here are answers to some commonly asked questions:

Who buys annuities?

Annuities are frequently purchased by retirees around age 60 to 70 seeking supplemental income. However, deferred annuities can also be used by younger investors for tax-deferred growth potential.

What is a non-qualified annuity?

A non-qualified annuity is purchased with after-tax dollars. You don’t get a tax deduction on premiums, but annuity earnings grow tax-deferred. RMDs and withdrawals are taxed as ordinary income.

What is the surrender period?

The surrender period refers to the time period after purchasing an annuity where you will face surrender charges for withdrawal. Typical surrender periods are 5-15 years.

What’s the difference between fixed and variable annuities?

Fixed annuities provide a guaranteed, predictable return, while variable annuities offer investment returns tied to underlying subaccounts similar to mutual funds

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