An annuity is a financial product that pays out a fixed amount of money in a series of payments. Annuities are popular — sales of annuities increased by 17% in 2022, beating the previous record from 2008. They are also polarizing — a quick Google search reveals a number of websites warning you to stay away from annuities.
Despite the debate, annuities serve a purpose. These products were products designed specifically to provide guaranteed income, which is one reason you may decide to include one in your retirement plan. However, annuities are complex products that come in a variety of distribution structures and riders. Learning more about annuities and how they work can help you understand their role in helping you prepare for the rest of your life.
What Is the Purpose of an Annuity?
The primary function of an annuity is to remove longevity risk for retirees. Many people are frightened by the prospect of outliving the money they accumulate during their working years. As the average lifespan increases and the number of pensions decreases, this fear has become a real problem for financial planners.
More than ever, people are forced to rely on personal savings and investments to generate cash flow for basic needs in retirement if they don’t want to make major life changes, such as getting housemates or moving to a less expensive area.
The situation is exacerbated by fears that the Social Security system won’t have enough money to cover future generations that retire. Annuities, therefore, can be useful tools to transfer longevity risk from individuals to insurance companies. Even with their apparent advantages, however, annuities also have potential downsides that might make them unsuitable for certain people.
What Is an Annuity?
An annuity is a contract between up to four parties:
- Owner: The owner is the person who buys the annuity.
- Annuitant: The annuitant is the one who gets the benefit payments and is often the same as the owner.
- Beneficiary: The beneficiary receives death benefits payable under the annuity contract, if applicable.
- Issuer: The issuer is the company that issues the annuity, such as an insurance company, and pays benefits when the time comes.
Payment amounts in the distribution phase are based on the annuitant’s life expectancy.
How Does an Annuity Work?
Annuities are divided into two phases:
- Accumulation phase: The accumulation phase, sometimes called the investment phase, is the first of the two. This is the period during which contributions are made to the account and funds grow. Appreciation during this time is based on contractual guarantees or investment performance, depending on the type of annuity purchased.
- Annuitization phase: The second phase is the annuitization, or payout, phase. This is when payments start being made to the annuitant. These payments can be a lump sum, periodic payments or some combination of the two. The amount paid out is determined by the amount contributed, the performance of the account, the expected lifespan of the annuitant and the type of distribution elected by the owner.
Annuities come with several distribution structures that outline how you receive your payments. The most common options include life only, joint and survivor life, fixed amount and fixed period. Here’s how they compare:
- Fixed amount: You receive payments in a fixed amount until you have no money left in the annuity or you request them to stop. This option does not provide guaranteed income for the rest of your life, but it does give you a predictable income stream.
- Fixed period: You receive payments for a specific length of time, such as 10 or 20 years. If you die before the period ends, your beneficiary can receive the rest of the contracted payments.
- Joint and survivor life: You or your survivor receive guaranteed payments for the rest of your lives. With this structure, you receive the payments until your death. At that point, your survivor receives the payment you agreed to for the rest of their life.
- Life only: You receive guaranteed payments for the rest of your life. This doesn’t mean you automatically get back all of the money in the annuity, but you’ll have a regular payment that you can count on. Your life expectancy plays a factor in how much you’ll receive — the longer you’re expected to live after payments start, the smaller they’ll be.
A certain option triggers payouts for a defined amount of time — even if the annuitant passes away before that period is reached. Annuity assets can also be distributed in lump sums.
What Happens to the Money in an Annuity When You Die?
Insurance companies usually return the capital contributed to the beneficiary if the owner passes away during the accumulation phase. There are also contract provisions that will pay a defined death benefit to survivors or pay out the remaining account values to beneficiaries.
Some distribution options continue to pay surviving spouses or beneficiaries upon the passing of the annuitant, whereas some annuities cease to provide income upon the death of an annuitant in the distribution phase of the product. Prospective buyers should consult the specific product and carrier to determine the right match of features before purchasing.
Types of Annuities
Numerous types of annuities are available, as well as different options and contractual terms that can impact outcomes. You’ll want to consider each of these features before committing to an annuity contract. Prospective annuity buyers should also consider the suitability of these vehicles as they relate to financial goals and needs.
Take a look at some of the types of annuities that might be options for you.
Fixed annuities are offered by life insurance companies and are contracts in which a policy owner contributes a certain amount of capital to an account. The insurance company makes a contractual guarantee that this capital will grow at a specified rate of return over time. In turn, the annuitant will be entitled to a set amount of periodic income during the distribution phase.
Contributions can be made once or numerous times over the accumulation phase, while distributions can start immediately or at some point in the future. Fixed annuities are primarily designed to provide a modest growth vehicle that is insulated from the volatility of equity and bond markets, and to provide guaranteed income in retirement.
Variable annuities share numerous features with fixed annuities, but they differ notably based on capital appreciation and future income payments.
Variable annuities do not offer the guaranteed growth rates of fixed annuities. Instead, contract holders can access these accounts by allocating contributed funds across equities, bonds, money market products and mutual funds.
When the contract enters the distribution phase, the insurance company will provide guaranteed income based on the asset levels achieved in the capital subaccounts.
Prospective buyers of variable annuities should be aware that the value of their assets in these products can decline when market conditions deteriorate, so they might not be ideal solutions for people worried about losing money in an annuity.
An indexed annuity is another type of annuity contract that blends characteristics of fixed and variable contracts. These products pay interest rates dictated by security indexes such as the S&P 500.
Indexed products offer higher growth potential relative to fixed vehicles and more downside protection than fully variable products. However, this downside protection doesn’t always prevent the account from producing net losses because the contractual floor might fall below the gross contributions.
Immediate and Deferred Annuities
The annuities mentioned above can also be classified as immediate or deferred.
Immediate annuities provide a guaranteed stream of income directly following a lump sum payment to the insurance company. This compresses the accumulation phase to a single contribution, with the distribution phase starting immediately.
Deferred annuities push the distribution phase out into the future, allowing one or multiple contributions to grow during the accumulation and investment phase.
These products are often structured as tax-deferred vehicles. They allow gains on the account to compound without any tax liability until qualifying withdrawals are made beyond retirement age.
Are Annuities a Good Investment?
The answer to the question, “Are annuities a good investment?” is not a simple one. First, an annuity is not generally considered an investment like stocks and bonds. It is an insurance contract, and you buy one from an insurance company. Variable annuities are an exception because the value of the annuity is tied to the performance of the stock market. For this reason, anyone selling a variable annuity product must have a securities license.
Second, you have to consider factors like your overall retirement plan, your risk tolerance, and benefit you will receive from the annuity. An annuity is not a substitute for a 401(k), and it cannot be your only source of retirement income. If the insurance company underwriting the annuity goes out of business, you may not be able to recover your money. Keep in mind that withdrawing money from the annuity early can lead to a loss.
The questions below might be some of the things you’re wondering about in regard to annuities and whether they are the right product for you.
What Are the Benefits of an Annuity?
Prospective annuity buyers should consider the advantages and disadvantages of these products and their suitability for their financial needs. One of the benefits is that annuities can be safe financial instruments for people worried about market or longevity risk. An annuity can provide a predictable income stream — you’ll know how much, when and how long to expect it. Those seeking tax deferrals can also benefit from annuities that accumulate tax-free, with only distributions in retirement being subject to income tax.
Another valuable benefit of annuities is the option to purchase riders to customize the product. Examples include living benefits riders that pays you or your spouse for the rest of your lives, and death benefits riders that allow you to designate a beneficiary, lock in a value, or provide for your spouse if you die before the end of the annuity period. You may notice the names of the riders can vary between companies, but they typically offer these benefits:
- Boost income benefit by a set percentage
- Give you access to the money in your annuity when you need it
- Provide a higher interest rate to increase potential earnings
- Pay for the cost of nursing home or home health care
- Guarantee a minimum income.
What Are the Disadvantages of an Annuity?
Annuities have some drawbacks as well. For one thing, you sacrifice liquidity for capital that is contributed to these products. While most annuities have a surrender value that allows contract holders to recoup assets they’ve contributed, these often carry surrender charges or, in the case of tax-deferred annuities, penalties paid to the IRS.
Annuities are often maligned for their high expenses — and with good reason. Variable and indexed products are often marketed or positioned as alternatives to mutual funds and other securities because they provide upside exposure, and the performance of subaccounts is directly correlated to market performance.
While these products are meant to mimic the performance of traditional investment accounts, they often do so in a less efficient manner. Fees tend to be higher in these accounts, both in the form of commissions to advisors and in internal fees for the management of subaccounts.
Cost is only an issue in the absence of value, but outcomes from variable annuities can often be replicated at lower expenses.
What Is Better: An IRA or Annuity?
Although both individual retirement accounts and annuities can be part of a retirement plan, they are different products with their own pros and cons. Whether you should have one or both of the products depends on your needs.
An IRA is essentially a tax-advantaged savings account in which your money grows tax free. Contributions to a traditional IRA are pre-tax funds, which means you’ll pay taxes on the money when you withdraw it during retirement. A Roth IRA is funded with money that’s already been taxed, so you enjoy tax-free withdrawals after you retire.
An annuity is a contract between you and an insurance company. You pay a lump sum to purchase the annuity, which the insurance company invests to generate income. During the payout phase, you can receive guaranteed payments to supplement your income from other sources.
Annuities can be costly, thanks to a complex fee structure and the additional riders you can purchase to add death benefits, long-term care coverage, and a minimum income guarantee. However, if you’re closer to retirement, you may find the predictability of an annuity more appealing. If retirement is still years away, an IRA may make more sense because you have time to take advantage of compound interest to grow the balance.
Annuity Vs. 401(k)
Annuities and 401(k)s are both used in retirement planning, but they are very different products. A 401(k) is a retirement savings account provided by many employers. They contribute to the fund — and some match the employee’s contributions to the fund — as a benefit for their workers. The funds are invested to generate income. Over time, these small payments made each year can add up to a hefty nest egg.
When you purchase an annuity, you typically make a lump sum payment instead of a series of small payments over the course of your career. Unlike the 401(k), which can gain and lose money when the stock market fluctuates, an annuity may give you guaranteed income. This guarantee comes with more fees.
Ultimately, suitability is the most important consideration in any investment. If capital growth is a priority, fixed annuities are not going to be the most efficient solution. If limiting volatility is the priority, variable annuities are unlikely to be the most appropriate product, either.
Retirees who have accumulated sufficient assets to generate ample cash flow from interest and dividends are often able to self-insure against longevity risk. When assessing the merits of annuity products and how they might fit into your financial plans, you’ll want to consider all of the above features with respect to your own needs and goals.
As with all investments, doing research in advance is essential. What works for one person may not be the best fit for the next. Annuities can be a bit complex. While they can be a good way to guarantee tax-deferred income, there may be better alternatives. Meeting with a fee-only financial planner who is not purely motivated in selling you a financial product could be helpful to create a retirement plan that works best for your goals.
FAQ on AnnuitiesHere are the answers to some commonly asked questions about annuities.
- Can you lose money in an annuity?
- Fixed annuities are considered relatively safe assets. As outlined above, they offer contractual guarantees from insurance companies, and account values only increase over time.
- Fixed annuities are only at risk of loss if an early surrender carries charges and penalties or if the insurance company becomes insolvent. Even in the case of insolvency, there is an industry organization designed to protect account holders that insures up to $250,000 of present value.
- Variable and indexed annuities are subject to the same risks, but they also carry market risk and could theoretically lose value if there is poor performance from the subaccounts they are designed to track.
This article has been updated with additional reporting since its original publication.
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