Finance

What Is an Annuity? How These Tricky Contracts Really Work

Guaranteed income for life sounds like a great deal. It’s what many annuities promise, yet nothing is ever as good — or as easy — as it seems.

If you’re considering purchasing an annuity to supplement your retirement income, it’s important to understand the risks, fees and restrictions involved.

Let’s get started.

What Is an Annuity?

An annuity is a contract between you and an insurance company where in exchange for paying them a sum of money, they agree to provide you with a steady income stream.

The purpose of an annuity is to keep you from outliving your retirement assets by acting like a paycheck during retirement. In some ways, they are similar to a pension, providing a set amount of income in exchange for turning over cash.

Annuities are not investments — they’re contracts. And like many contracts, annuities can get complicated.

“People say they’re confusing and they can be. They’re just not easy to understand and not easy for professionals to understand,” said Andrew Barnett, a certified financial planner with GFA Wealth Design based in Fort Myers, Florida.

How Do Annuities Work?

When you purchase an annuity, you either make a single lump sum payment or a series of payments over time to an insurance company.

Disbursements can begin almost immediately or at some designated point in the future. The payouts often last the lifetime of the policy holder.

You choose how frequently you receive future annuity payments, such as monthly, quarterly or yearly.

The funds enjoy tax-deferred growth, so you only pay taxes on the proceeds when you receive payments.

There is no contribution limit, but contributions do not reduce your taxable income the way traditional 401(k) contributions do. There is also a 10% penalty from the Internal Revenue Service (IRS) to withdraw any funds before age 59.5.

How Your Income Is Calculated with an Annuity

The dollar amount of annuity payments depends on the life expectancy of the person buying the policy. The younger you are when you start receiving income from an annuity, the smaller the payments will be since the payout stretches over a lifetime.

When you buy an annuity, you decide if you want income for a guaranteed period of time (called a period certain annuity), a lifetime or a combination of both.

How Annuities Got Started

Annuities became popular during the Great Depression from 1929 to 1933 when people worried about the volatility of the stock market and they wanted guaranteed income. As traditional company pensions became less common, annuities gained traction.

Unlike most other financial planning tools, annuities are insurance policies and the contracts are usually maintained by life insurance companies.

Like any other insurance policy, annuities transfer the risk from the owner of the annuity — called the annuitant — to the insurance company.

So what’s in it for the insurance company? To offset risk, the company charges a bevy of fees for management and administration.

Insurance companies also impose early withdrawal penalties, caps, spreads and participation rates on certain annuities, which reduces your overall return.

Some lifetime annuities have a rider that allows a beneficiary to receive annuity payments for the remainder of their lives should the primary policy holder die first. These are called joint and survivor annuities and are popular for married couples.

What Are the Different Types of Annuities?

There are many types of annuities, but most fall into several general categories based on how they pay out and how they earn money.

The methods of payout are either: 

And the way annuities earn money is either: 

Annuity Payout Options

The first decision when purchasing an annuity contract is deciding whether you want payments to begin now (immediate annuity) or in the future (deferred annuity).

Immediate Annuities

An immediate annuity begins paying within a year of purchase. Sometimes the waiting period is about 30 days.

An immediate annuity usually requires a large sum of cash to get started (think $50,000 and up).

Because of the quick payments, immediate annuities are popular with people who are either very close to retirement or already retired.

Deferred Annuities

Deferred annuities begin paying out sometime in the future.

You make an initial lump sum payment or a series of payments to the life insurance company. That money grows tax-deferred throughout the accumulation process.

You can choose how long the money accumulates in a deferred annuity. The typical range is 10 to 30 years.

In exchange for payments during the accumulation period, the annuity company promises to send you future income payments.

Once the distribution phase begins, you’ll begin receiving regular payments from your deferred annuity.

Types of Annuities

In addition to choosing the payout time frame, people buying an annuity need to decide how it will grow and the amount of risk they are willing to take.

Fixed Annuities

A fixed annuity pays a guaranteed amount based on a fixed rate. It’s considered relatively low risk.

Fixed annuities tend to have much lower costs and fees than variable or indexed annuities.

Returns are modest. Life insurance companies invest the funds in bonds and other fixed income investments so the money can grow.

Barnett compares a fixed annuity to a bank certificate of deposit, with a term and a set interest rate.

“A fixed annuity is not that different,” he said. “Instead of going to a bank, you go to an insurance company, and typically the insurance company might pay a little more than a bank.”

Variable Annuities

Variable annuities are riskier because future payments are based on the performance of underlying investments.

The policy holder can choose a variety of mutual funds to invest in, much like a 401(k) or a Roth retirement account.

Funds usually go into sub-accounts and the overall return is based on how those sub-accounts perform. Once the annuity payout phase begins, you’ll get your payments back plus any investment income and gains.

However, investment gains inside a variable annuity are almost always capped at a certain percentage.

“It’s not an unlimited upside, it’s always limited,” Barnett said. “The insurance company will tell you, ‘This can only make 3% a year, if the market goes up 40%, you only get three.’ So the insurance company is taking the risk for you and they’re taking some of the profits, and you have to be OK with that.”

Variable annuities also carry the highest fees.

Indexed Annuities

Indexed annuities — sometimes called fixed indexed annuities — are a bit of a combination of both fixed and variable annuities with a mix of risk and reward.

With an indexed annuity, there is a possibility of a higher payout based on the performance of a stock market index, usually the S&P 500.

Like a variable annuity, gains are capped at a certain percentage.

What Are Typical Annuity Fees?

In addition to being confusing, many investment experts pan annuities because of their high and complex fee structure.

Generally, the more complicated the annuity contract, the higher the costs.

For every customization and add-on like a guaranteed death benefit, guaranteed withdrawal benefit, addition of a spouse, etc., there is an extra cost — usually a percentage of the proceeds.

On average, annuity fees can range between 2.3% to 3% of your account balance each year.

All annuities charge commission, which is usually baked into the price. Commissions aren’t highlighted in annuity contracts, so you won’t see them taken out or called fees like you may in other types of retirement accounts.

Fixed annuities, which are relatively straightforward, tend to charge the lowest fees. But insurance companies build heavy fees into other types of policies, like variable and indexed annuities.

Besides commissions, the annuity company will charge administration and mortality fees, among others.

What Are Surrender Charges?

Annuities are meant to achieve long-term goals, like retirement. Because of this, the annuity principal will be tied up for a period of time.

Annuities come with surrender periods during which you’re not supposed to withdraw money or cancel the contract.

Surrender periods usually last six to eight years.

You will owe substantial taxes, surrender charges and other penalties if you try to terminate the annuity contract or withdraw money early.

Early withdrawal fees and penalties can range from 7% up to a whopping 20% of your entire deposit.

What Are the Benefits of Annuities?

While high fees are a drawback, annuities can make sense for some people in certain situations.

In general, Barnett said annuities are good for people with a family history of longevity who are concerned they might outlive their retirement savings and want to guarantee further income.

Guaranteed Income

The biggest draw of annuities is guaranteed retirement income. Setting up an annuity with lifetime payments can help you avoid market volatility and take the guesswork out of retirement planning.

Deferred Taxes

Tax-deferred growth is another benefit of annuities.

“Any growth that you have is non-taxable until you take the money out, which is great,” Barnett said.

When you take the money out, proceeds are taxed as ordinary income and not as capital gains.

What Are the Downsides of Annuities?

People who have accumulated substantial assets and are not concerned about running out of income are not good candidates for annuities, nor are people with health problems that could make reaching their life expectancy unlikely.

Leaving Money on the Table

Losing out on possible wealth accumulation is a huge downside with annuities. Insurance companies make their money by investing your cash and often paying you much less than if you were investing it on your own, reducing your potential wealth.

“If the market went up 10% a year, you could buy a mutual fund and get that 10%,” Barnett said. “But if you have your money in an annuity with 4% fees, now you only get 6% a year. That’s really going to end up reducing your wealth in the long run.”

Different ethical standards

There are some ethical issues, too. People who sell annuities usually work for an insurance company as broker dealers. Unlike certified financial planners — which uphold a fiduciary standard by putting their clients’ interests first — insurance salespeople often earn high commissions by pushing expensive products.

“I don’t have anything against paying for insurance, which is basically what you’re paying for, and I don’t have anything against paying for insurance if it’s something that you need … and you understand what the cost is,” Barnett said. “Make sure you do your homework and whether you engage a financial advisor to help you or you do research on your own, don’t rush into anything.”

Frequently Asked Questions (FAQs)

Where Can You Buy an Annuity?

Many big-name insurance companies sell annuities, including Nationwide and State Farm. Other financial institutions — including banks, brokerage firms and mutual fund companies — may also sell annuities.

What Is an Annuity Rider?

When you purchase an annuity, you get the option to add annuity riders to your contract. A rider is an extra benefit or guarantee. For example, a cost-of-living-adjustment rider guarantees that your annuity payments will gradually increase over time. Each rider costs money, usually 0.5% to 1% of your contract.

What Is a Surrender Period?

The surrender period usually lasts six to eight years after you buy an annuity. During this time, you can’t access your money ahead of schedule or make a large withdrawal.
Withdrawing funds during the surrender period will result in hefty surrender charges, which eat into the value of — and the return on — your investment.

Rachel Christian is a Certified Educator in Personal Finance and a senior writer for The Penny Hoarder.

Tiffani Sherman is a Florida-based freelance reporter with more than 25 years of experience writing about finance, health, travel and other topics.


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