What Is an Annuity?
Annuities are financial products that provide tax-deferred income designed to mitigate the risk of outliving savings during retirement. They can be purchased from an insurance company with either a single lump sum or a series of payments.
- Written by Rachel Christian
Financial Writer and Certified Educator in Personal Finance
Rachel Christian is a writer and researcher for RetireGuide. She covers annuities, Medicare, life insurance and other important retirement topics. Rachel is a member of the Association for Financial Counseling & Planning Education.Read More
- Edited ByMatt Mauney
Matt Mauney is an award-winning journalist, editor, writer and content strategist with more than 15 years of professional experience working for nationally recognized newspapers and digital brands. He has contributed content for ChicagoTribune.com, LATimes.com, The Hill and the American Cancer Society, and he was part of the Orlando Sentinel digital staff that was named a Pulitzer Prize finalist in 2017.Read More
- Financially Reviewed ByToby Walters, CFA®
Toby Walters, CFA®
Chartered Financial Analyst and Paraplanner
Toby Walters, CFA®, has over 25 years of financial research experience. With a knowledge and understanding of researching and analyzing financial data, he has developed a unique and experienced viewpoint on money matters. He has been a chartered financial analyst since 2003, and most recently a portfolio analyst and paraplanner.Read More
- Published: April 22, 2020
- Updated: April 27, 2023
- 6 min read time
- This page features 7 Cited Research Articles
How Do Annuities Work?
Annuities are popular financial products for retirement because they offer tax-deferred growth and a guaranteed income stream.
You can purchase an annuity in a single payment, called a lump-sum premium, or with multiple payments.There are two phases to an annuity contract:
- Accumulation: The savings phase.
- Distribution: The payout phase.
Annuities work by offering flexibility and hedging against longevity risk — the threat of running out of money in retirement.
Payout options for annuities include a lump sum, a series of payments distributed over a specific time period or guaranteed payments for life.
Annuities vs. Life Insurance
Annuities and life insurance share similarities. Both offer protection against risk and take the form of a written contract between you and an insurance company.
However, these products serve very different purposes.
Life insurance is protection in case you die too soon. An annuity is protection against outliving your money.
In other words, life insurance protects your beneficiaries if you pass away prematurely while an annuity protects your income if you live longer than expected. Both are common components of retirement planning.STEP 1STEP 2STEP 3
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Types of Annuities
Annuities come in all shapes and sizes. The right type of annuity for you depends on many factors, including your income, risk tolerance and when you want to begin receiving payments.
A fixed annuity guarantees a return of your premium plus a minimum interest rate. The interest rate may be guaranteed or may fluctuate from year to year, depending on your contract.
Fixed annuities are considered predictable ways to ensure income after exiting the workforce. Payouts are not affected by fluctuations in the market, so they can provide peace of mind for those nearing retirement.Highlights of Fixed Annuities
- Earns a guaranteed rate of interest for a specific period of time.
- Backed by the insurance company that issues it.
- The simplest type of annuity.
- Payments typically do not have cost-of-living adjustments to keep pace with inflation.
- Money grows on a tax-deferred basis.
Fixed Index Annuities
According to the U.S. Securities and Exchange Commission, interest rates for indexed annuities are tied to an equity index, such as the Nasdaq. Indexed annuities carry more risk than fixed annuities, but less risk than variable annuities.Highlights of Fixed Indexed Annuities
- Earns interest based on a market index, such as the S&P 500.
- Money grows tax deferred.
- Preserves your principal.
- Guaranteed minimum rate of return.
- You don’t lose money if the stock market underperforms.
With a variable annuity, the money you pay is allocated to an investment portfolio. These underlying investments, or subaccounts, may include stocks, mutual funds, bonds, money market funds or other options.
The amount of money you receive will vary depending on how much money you put in and the performance of your underlying investments.
You may be able to purchase a rider for an extra fee that offers a guaranteed minimum withdrawal or income benefit, even when market performance is poor.Highlights of Variable Annuities
- Earns interest through investments you select within the annuity.
- Does not guarantee a return but offers more growth potential.
- Money grows tax deferred.
Qualified Longevity Annuity Contracts (QLAC)
Qualified longevity annuity contracts (QLACs) are financial products that provide regular income payments to individuals starting at a specified age, typically age 80 or 85. These annuities are designed to help retirees avoid outliving their savings by transferring the risk of longevity to an insurance company.
QLACs are unique from other types of annuities in that they can be purchased with funds from a qualified retirement account such as a 401(k) or IRA and are exempt from required minimum distribution rules until age 85.Highlights of QLACs
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- They offer guaranteed lifetime income.
- Can be purchased with funds from a qualified retirement account.
- Exempt from required minimum distribution rules until age 85.
- Provide tax-deferred growth.
- Can help protect retirement savings from market volatility.
- Transfers the risk of longevity to an insurance company.
How to Buy an Annuity
Annuities are sold by insurance companies as well as some banks, brokerage firms and mutual fund companies.
Three Ways to Purchase an Annuity
Steps for Buying an Annuity
- You can transfer funds from an existing annuity or retirement account.
- You may purchase an annuity within a 401(k) plan offered to you by your employer.
- You can fund an annuity using cash from your bank account.
- Assess your current and future financial needs.
- Select your provider. Do your homework. Select a company with a reliable reputation and sound financial history. Annuities are regulated by state insurance commissioners. Be sure to check with them to confirm that your broker is registered to sell insurance in your state.
- Choose an annuity that meets your needs, and carefully review contract terms. High expenses and fees can erode an annuity’s value. It’s critical to shop carefully to ensure you get the best deal. All fees should be clearly detailed in your contract.
- Complete the application.
- Transfer funds.
The Role of Annuities in Retirement
One of the greatest benefits of an annuity is a guaranteed income stream that gives people peace of mind by ensuring their needs will be met during retirement.
Annuities provide what the industry calls “longevity insurance,” or protection against outliving your savings.
Pensions are increasingly rare in the United States and Social Security may not cover all your living expenses. A retirement savings account, such as a 401(k), can help bridge this gap, but these plans don’t offer the same income guarantee as annuities.
Annuities are also beneficial for retirees because they offer a death benefit to loved ones. If you die before you start receiving annuity payments, your designated beneficiary will receive payment instead.Last Modified: April 27, 2023Share This Page
7 Cited Research Articles
- Chorpenning, A. (2020, January 2). Annuities vs. Life Insurance: Key Differences. Retrieved from https://finance.yahoo.com/news/annuities-vs-life-insurance-key-161944046.html
- U.S. Securities and Exchange Commission. (2020, July 31). Updated Investor Bulletin: Indexed Annuities. Retrieved from https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/updated-13
- CNN Money. (n.d.). What are the advantages of annuities? Retrieved from https://money.cnn.com/retirement/guide/annuities_basics.moneymag/index4.htm
- Financial Industry Regulatory Authority. (n.d.). Fixed Annuities. Retrieved from https://www.finra.org/investors/investing/investment-products/annuities
- U.S. Securities and Exchange Commission. (n.d.). Annuities. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/annuities
- U.S. Securities and Exchange Commission. (n.d.). Guide to Variable Annuities. Retrieved from https://www.sec.gov/investor/pubs/sec-guide-to-variable-annuities.pdf
- Wall Street Journal. (n.d.). How to Select and Shop for an Annuity. Retrieved from https://www.wsj.com/articles/BL-HOWTOPFB-8
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