What Is an Annuity and How Does It Work?

Learn about what an annuity investment can do for you, how it can be used for retirement planning, what types of annuities are available and what costs are involved.
By Richard Barrington
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In a time of volatile markets and low interest rates, many investors are just looking for a little certainty. Annuities are a popular option for taking some of the uncertainty out of investing, but they are not always the best solution.

If you want to figure out how well an annuity might meet your needs, it helps to understand the basics of how they work.

This article addresses questions such as:

  • What is an annuity investment?
  • How does an annuity work?
  • What types of annuity investments are there?
  • What is an annuity fund for?
  • What are the pros and cons of annuities?
  • How do I shop for annuities?

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What is an Annuity?

An annuity is a contract with an insurance company designed to provide future income.

In exchange for a premium, the insurance company will pay you income according to a predetermined formula. This income stream is generally designed to last for the lifetime of the annuity owner, and some annuities may also have death benefits for a designated beneficiary.

Essentially, an annuity lets you delegate the responsibility of investing for your future to the insurance company. This may take some of the uncertainty out of the process for you, but it comes at the cost of the premiums and other expenses on the annuity.

Because costs and payout formulas vary greatly from one annuity to another, it is important to compare the details before buying an annuity.

How Do Annuities Work?

Annuities allow you to somewhat guarantee the outcome of your investments. Instead of investing money yourself and depending on the performance of those investments for future income, you can give the money to an insurance company in the form of an annuity premium.

In exchange, the insurance company will make payments to you in the future. The size and type of these payments vary according to the terms of the annuity.

Lifetime payments

One of the primary attractions of an annuity is that the payments are designed to continue for the lifetime of the annuity owner. A major risk in retirement planning is the possibility of outliving your savings. An annuity addresses this by providing for a stream of payments over the remainder of your life.

Death benefit

Another feature of some annuities is a death benefit. In exchange for an additional premium, you can provide for a payment to someone you designate as a beneficiary upon your death.

Essentially, the death benefit is like adding a life insurance element to the annuity contract. How worthwhile it is depends largely on how much you pay for it relative to the eventual payout to your beneficiary.

Tax advantages

Another feature of annuities is the tax-advantaged treatment of investment earnings.

Unlike contributions to traditional IRAs or 401(k) plans, annuity premiums are not tax-deductible. However, taxes on annuity earnings are deferred until they are paid out of the annuity. Delaying taxation in that way keeps more money compounding within the annuity.

Types of Annuity Investments

Two keys to how annuities work is how they pay out their benefits and when those payments begin.

First, consider three types of payout methods:

  • Fixed annuity
  • Variable annuity
  • Fixed index annuity

Fixed annuity

A fixed annuity is designed to pay a specified income amount on a regular cycle - monthly, quarterly or annually.

A good way to think of this is as supplementing Social Security payments or other retirement income. A fixed annuity can provide a predictable stream of income payments to help you make ends meet in retirement.

Variable annuity

A variable annuity is more of an active investment than a fixed annuity - for better or worse.

With a variable annuity, you are able to choose from a variety of investment funds offered by the insurance company. The payments you get depend on the returns of the annuity funds you've chosen. If those funds perform poorly, you might get less out of the annuity than you put into it.

Fixed index annuity

This is kind of a hybrid between a fixed and variable annuity.

Your payouts are linked to the performance of a market index like the S&P 500, but you don't get the full return of that index.

The payout on a fixed index annuity can vary more than that of a fixed annuity, but typically less than that of a variable annuity.

As for when annuity payments begin, you have two choices:

  • Immediate annuity
  • Deferred annuity

Immediate annuity

As the name suggests, with an immediate annuity, payouts start right away. You would give the insurance company a lump sum of money, and they would convert that to a stream of future payments.

Deferred annuity

With a deferred annuity, you would typically make a series of payments to the insurance company over time in exchange for a series of payouts that would start on a specified date in the future.

A deferred annuity allows you to save for the future gradually. It also gives you an opportunity for a higher payout than an immediate annuity, based on investment growth between when you make your payments and when you start drawing money out.

Uses for Annuities

Investors who want to provide for the future face two main challenges: building up enough savings to live on in the future, and managing those savings so they last long enough. Annuities can help with both types of problems.

A deferred annuity can be used to build up savings over time. This makes saving for the future more manageable. An annuity also takes care of investing those savings for you and, in the case of a fixed annuity, can even give you some certainty as to what you'll get out of your savings in the future.

If you already have money and are concerned with making it last, an immediate annuity can help. It can manage your money so that it can be paid out in regular increments over your lifetime.

A immediate annuity can be useful if you are ready for retirement and want an investment that will provide for regular payments in the future. It can also be used if you have a sudden windfall - such as an inheritance or lottery win - and want an investment that will help make that money last.

Benefits of Annuities

Annuities can make managing your money easier by handling key aspects of the process for you.

Annuities calculate how much you would have to put in to accumulate a certain target amount over time. They set up a payment schedule that keeps you on track toward your savings target.

Then, the insurance company invests the money on your behalf, based on the type of annuity you have selected. This saves you the effort of having to find appropriate investment vehicles, plus having to manage and monitor those investments over time.

Finally, the annuity contract manages the eventual series of payouts to you. This saves you having to calculate how much you can spend and still make your savings last.

Besides making it easier to manage money, annuities address one of the big uncertainties about retirement planning - not knowing how long you will live.

Annuities can guarantee continuing payments over the remainder of your life. This can help reduce the risk of outliving your savings.

Annuities can also provide for a beneficiary after you die, if you choose a contract that includes death benefits.

Drawbacks of Annuities

There are three major concerns you should recognize before you choose an annuity:

Cost

Annuities can be expensive because they involve several layers of costs:

  • Premiums - this is the money that goes toward providing your future benefits
  • Death benefit premiums - this is the cost if you want to add a life insurance element to your annuity contract
  • Commissions - these are payments to the insurance agent who sold you the annuity
  • Investment management fees - these compensate for the ongoing handling of the annuity fund
  • Surrender charges - these are extra fees if you take money out of the annuity either ahead of schedule or in excess of the planned amount

Complexity

Annuities combine several things. They provide a plan to help you save, they handle investing money for you, they schedule the timing and amount of future benefit payments to you and they can even provide death benefits to a designated beneficiary.

Handling all of that may make your life easier, but it also makes it harder to tell if you're getting a good deal.

You can compare different annuities, but to really tell whether they are worthwhile you'd have to compare whether you could accomplish all the same things less expensively by planning your savings, choosing your investments and buying life insurance yourself.

Counter-party risk

Though annuities feature guaranteed payments, it's important to remember that they are only guaranteed by the insurance company issuing them. There is no government or other external guarantee to backstop them.

Instances of insurance companies defaulting on annuity contracts have been extremely rare, and would only be likely to happen under extreme circumstances. However, it is under extreme circumstances that risk management matters the most.

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Shopping for Annuities

If you're thinking of buying an annuity, be sure to go step by step to make sure you know what you're getting into.

  1. Decide what type of product you want.

    Because the timing and type of annuity payments vary, you need to think about your future needs and match the type of annuity contract you consider with those needs.

  2. List all the benefits.

    For each annuity contract you consider, start by listing the benefits it promises. This includes the amount of the payments, whether those payments are fixed or variable, when you would start receiving payments and whether there are any death benefits.

  3. List all the costs.

    Alongside the benefits, you should also list all the costs of the annuity. This includes premiums, commissions, investment management fees, surrender charges and any other fees.

  4. See which annuity offers the best trade-off of costs and benefits.

    Compare the total value of an annuity's benefits with all of the costs involved to see which offers the best deal.

  5. Check non-annuity alternatives.

    Once you know the best cost-benefit trade-off available from an annuity, consider whether you could do better on your own. This would entail choosing investment vehicles, planning savings and payout schedules, and possibly buying insurance to provide death benefits.

Annuities can be useful vehicles, but they are also very complex. They are not something you should buy without doing some research and comparison-shopping first.

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