How Do Annuities Work?
An annuity is a contract issued by an insurance company that provides specific guarantees on either a rate of return or a stream of income. Annuities come in various types, each offering optional features. Learn how they work and how to use them to enhance your retirement income plan.
- Written by Stephen Kates, CFP®
Stephen Kates, CFP®
Principal Financial Analyst for RetireGuide.com
Stephen Kates is a Certified Financial Planner™ professional and personal finance expert with over a decade of experience working with individuals and families who need help with their finances. With experience as a financial advisor for two of the largest financial firms in the country, Stephen has worked with hundreds of clients to build comprehensive financial plans to grow and protect their wealth.
Read More- Edited By
Michael Santiago, CRPC™Michael Santiago, CRPC™
Senior Financial Editor
Michael Santiago, a senior financial editor, joined RetireGuide in 2023. With over 10 years of professional writing and editing experience, he brings a wealth of expertise in creating content for diverse industries, including travel and healthcare. Having traveled to more than 40 countries across five continents and lived in Europe and Asia for several years, Michael's global perspective enriches his work. He combines his strong writing skills, editorial judgment and passion for crafting accurate and engrossing content to enhance the user experience on RetireGuide.
Read More- Published: October 4, 2021
- Updated: November 23, 2024
- 9 min read time
- This page features 8 Cited Research Articles
- Edited By
- Annuities are one of many different types of retirement investment products and can play an important role in providing secure growth or income in retirement.
- There are two broad categories of annuities: income annuities and accumulation annuities.
- The most common type is an income annuity, which offers a stream of guaranteed income for retirement.
Introduction to Annuities
An annuity, in the strictest sense, is a contract between you and an insurance company. This agreement states that you will give the insurance company a certain amount of money, and in exchange it will pay you a predictable and guaranteed amount for a specified length of time.
An annuity is a series of payments designed mainly for retirement income. One of the most common and well-known types of annuities is a pension.
Annuities are one of many financial products designed for retirement saving and investing. Like any tool, they serve a specific purpose. Most annuities are intended to provide stable, guaranteed rates of return or income before and during retirement.
There are many types of annuities, each with its own benefits and drawbacks. When considering purchasing an annuity, it’s essential to know the following information.
- How do different kinds of annuities work?
- When are annuities most beneficial for investors?
- What kind of people purchase annuities?
- How do annuities compare to other investment and retirement products?
How Annuities Work
Annuities come in various forms, each designed with specific purposes, advantages and disadvantages. Just as you wouldn’t use a screwdriver in place of a wrench, you shouldn’t use annuities interchangeably.
These products generally fall into two main categories—income annuities and accumulation annuities—depending on their primary purpose for the owner.
Income Annuities
Income annuities pay out a guaranteed income stream now or in the future.
An immediate income annuity starts providing income within 1 to 12 months from the purchase date. For instance, a Single Premium Immediate Annuity (SPIA) is funded with a lump sum and delivers lifetime income within a year.
On the other hand, a deferred income annuity (DIA) begins paying income more than 12 months after purchase, or may not have a specific start date. It offers guaranteed growth on contributions until the scheduled income date, at which point it converts to an immediate income annuity and starts paying out a steady stream of income.
- Frequency of payouts: Monthly, quarterly or annually
- Payment start date: Whether payments begin immediately or at a future date
- Duration of payments: Whether payments will continue for the rest of your life or a specific period
- Number of lives covered: Payments may be made over one life or two lives (such as for you and your spouse)
- Payment structure: Either level payments (unchanging over the life of the policy) or a Cost of Living Adjustment (COLA) to increase payments over time
- Guarantee period or cash refund feature: Ensures a certain amount of money is paid out
Accumulation Annuities
Accumulation annuities grow the owner’s assets over time and may or may not be turned into income in the future. Annuities come with different types of returns, which can be broadly categorized into fixed and variable returns.
Fixed return contracts offer a predetermined and guaranteed rate of return for a specific term, after which the rate may no longer be guaranteed. While Certificates of Deposit (CDs) are not annuities, they provide a similar fixed rate of return for a set period before maturing. A Multi-Year Guaranteed Annuity (MYGA) operates in a similar manner, ensuring a guaranteed return over a specified term.
In contrast, variable returns allow returns to fluctuate based on market performance. These annuities typically invest in mutual funds or are linked to market indices such as the S&P 500 or the Barclays Aggregate Bond Index. A common example is the variable annuity, which offers tax-deferred market exposure and often includes options to add guarantees related to future income, withdrawals or death benefits through optional riders.
As annuities have evolved, financial companies have introduced products that blend guaranteed returns with market-based returns. These innovative products provide investors with the opportunity to benefit from market growth while maintaining some level of downside protection, offering a balanced approach to growth potential and risk management.
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How Do Insurance Companies Make Money on Annuities?
Insurance companies, like those offering financial advice, mutual funds or brokerage services, sell products for profit. They primarily earn money on annuities through investment earnings and annual fees.
Investment Earnings
Most annuities generate income for insurers by paying out less to policyholders than what the insurers earn from investing the principal payments. By securing a higher rate of return on these investments than the payouts made, insurers can cover their guarantees, business expenses and liabilities while aiming to book a profit.
For example, an insurer offering an immediate income annuity with a 6.0% payout rate for guaranteed lifetime income expects to earn more from investments than it will pay out over the policy’s duration. By applying the Law of Large Numbers, the insurer can estimate with relative certainty the lifespan of policyholders and compare total payouts to expected investment earnings. By distributing this risk across thousands of policies, the insurance company can offer attractive guarantees to policyholders seeking reliable income payments.
Annual Fees
Some annuity contracts, particularly those with variable or market-based returns, have annual or product fees. These fees may include a flat annual percentage fee for owning the annuity or additional percentage fees for optional contract riders.
The application of these fees varies by contract, so annuity customers should review and evaluate them carefully before purchase. An annual fee does not automatically mean the product lacks value. As with any investment product, fees are important and you should compare similar products to achieve the best results and security for your money. However, keep in mind that certain guarantees often require compensating the insurer for the associated risks.
Are Annuities Good Investments?
Annuities can be good investments when circumstances are right. Whether someone should buy one depends on various factors, as everyone’s financial situations, needs and priorities are different.
Like many financial decisions, building a retirement plan can be complicated. Annuities are a useful tool, but one type may be perfect for one person while another might need a different type. For example, a couple with no children who are uncomfortable managing their investments might find a joint income annuity that provides a guaranteed monthly income for life ideal for a carefree retirement. Income annuities can be excellent for creating enough guaranteed income to cover all essential expenses.
On the other hand, a pre-retiree in a high tax bracket who is a few years from retirement and concerned about economic fluctuations might benefit from a MYGA. This option offers a guaranteed rate of return and tax deferral, helping to minimize taxes until retirement.
However, if you have a pension and Social Security that cover most of your annual expenses, you likely won’t need an annuity. In this case, you essentially already have a form of guaranteed income through your pension, and additional guarantees may not be necessary.
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Annuity Pros and Cons
Annuities offer a range of benefits, such as guaranteed income and tax-deferred growth, making them a valuable tool in retirement planning. However, they also come with potential drawbacks, including fees and limited liquidity. Understanding both the advantages and disadvantages of annuities is key for determining if they align with your financial goals and needs.
- Guaranteed source of income
- Tax-deferred growth
- Customizable features
- Difficult to access money ahead of schedule
- Surrender charges and fees apply
Annuities sold in every state include a Free Look Period, which typically ranges from 10 to 30 days (varying by state). This period allows you to review and potentially cancel the policy without incurring any costs or penalties. It provides additional time to reflect on the policy and ensure it is the right decision for you.
Annuities vs. Other Retirement Investments
Annuities are investment products as well as income sources. Unlike other investments such as stocks, bonds or mutual funds, they allow you to transfer the risk of outliving your retirement savings to an insurance company that will guarantee your rate of return or your stream of income.
Annuities can help diversify your portfolio or support your investment goals by minimizing the income demand on your invested assets. Their stability and relatively safe nature can help balance higher-risk investments that fluctuate with the stock market.
- 401(k)
- A 401(k) is a retirement savings account provided by employers, allowing you to invest in mutual funds, stocks and bonds. Both annuities and traditional 401(k) accounts offer tax deferral until the money is withdrawn. However, contributing to a traditional 401(k) provides a tax deduction, while annuity contributions do not.
- Mutual Fund
- A mutual fund pools money from multiple investors and allocates it into stocks, bonds or other assets, forming the fund’s portfolio. Both mutual funds and annuities charge fees, and variable annuities often provide the option to invest in mutual funds through the annuity’s subaccounts.
- Individual retirement account (IRA)
- A traditional IRA is a retirement investment account that allows you to invest in stocks, bonds, mutual funds or other assets to build your retirement savings. Like annuities, withdrawals from traditional IRAs are fully taxable as income. The IRS imposes a 10% penalty for withdrawals from both annuities and IRAs before age 59 ½. While annuities generally have higher fees than IRAs, they do not have annual contribution limits.
- Roth IRA
- Unlike a traditional IRA, with a Roth IRA, you pay taxes on your contributions upfront. In return, withdrawals in retirement are tax-free. Additionally, Roth IRAs aren’t subject to the same IRS penalties for withdrawals before age 59 ½. If you use money from a Roth IRA to purchase an annuity, you will only be taxed on the earnings instead of the entire annuity withdrawal.
- Bonds
- Bonds and annuities are both fixed-income assets, offering relative safety and predictability. A bond functions as a loan from an investor, who receives regular interest payments from the borrower over a set period before the principal is repaid. Both annuities and bonds have specific payment dates, with the issuer guaranteeing the payments in each case.
Retirement accounts and retirement-focused investment options, such as annuities, should be viewed as tools to help achieve the ultimate goal of building a solid retirement plan. Each account has its own strengths and weaknesses, and many investors will find that different options become more relevant as they approach retirement.
Annuities, in particular, stand out by offering safe, predictable returns and guaranteed lifetime income. For soon-to-be retirees looking to step into retirement with confidence, these benefits can be more appealing than the higher risk and potential rewards of stock market investments.
Editor Norah Layne contributed to this article.
8 Cited Research Articles
- Internal Revenue Service. (2024, September 3). Roth 401(k), Roth IRA, and Pre-Tax 401(k) Retirement Accounts. Retrieved from https://www.irs.gov/retirement-plans/roth-comparison-chart
- Fidelity Investments. (2024, April 16). Understanding Annuities. Retrieved from https://www.fidelity.com/learning-center/personal-finance/retirement/what-is-an-annuity
- The National Council on Aging. (2024, January 16). What Is an Annuity and How Does it Work? Retrieved from https://www.ncoa.org/article/what-is-an-annuity-and-how-does-it-work
- Wettstein, G., Munnell, A. H., Hou, W., et al. (2021, March 2). The Value of Annuities. Retrieved from https://crr.bc.edu/working-papers/the-value-of-annuities/
- U.S. Securities and Exchange Commission. (2005, October 17). Mutual Fund. Retrieved from https://www.sec.gov/investor/tools/mfcc/mutual-fund-help.htm
- Alliance for Lifetime Income. (n.d.). Protected Retirement Income and Planning Study. Retrieved from https://www.protectedincome.org/prip/
- Financial Industry Regulatory Authority. (n.d.). Investment Products 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/glossary/annuities
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