Guide to Annuities: What They Are, Types, and How They Work

An annuity is a contract that's issued and distributed by an insurance company and bought by individuals. The insurance company pays out a fixed or variable income stream to the purchaser beginning right away or at some time in the future in exchange for premiums they've paid. It's not the same as a life insurance policy that only pays benefits when the insured dies.

People invest in or purchase annuities by making monthly premium payments or lump-sum payments. The holding institution issues a stream of payments for a specified period of time or for the remainder of the annuitant's life.

Annuities are used primarily for retirement income purposes. They can help individuals address the risk of outliving their savings.

How an Annuity Works

Purpose

Annuities are designed to provide a steady cash flow for people during their retirement years to alleviate the fear of outliving their assets. These assets may not be enough to sustain their standard of living, however, so some investors may turn to an insurance company or other financial institution to purchase an annuity contract.

These financial products are appropriate for investors, known as annuitants, who want stable, guaranteed retirement income. Invested cash is illiquid and subject to withdrawal penalties so it's generally not recommended that younger individuals or those with liquidity needs use this financial product.

Phases

An annuity has different phases:

• The accumulation phase or period when an annuity is being funded and before payouts begin and the money invested grows on a tax-deferred basis
• The annuitization or payout phase which kicks in after payments to the investor begin

Immediate vs. Deferred

Annuities can be immediate or deferred.

Immediate annuities are often purchased by individuals of any age who have received a large lump sum of money such as a settlement or lottery win and prefer to exchange that money for cash flows into the future. Deferred annuities are structured to grow on a tax-deferred basis and provide annuitants with guaranteed income that begins on a date they specify.

Regulation

Variable annuities are regulated by the Securities and Exchange Commission (SEC) and state insurance commissioners. Fixed annuities aren't securities so they're regulated by state insurance commissioners rather than the SEC. Indexed annuities are normally regulated by a state insurance commissioner. They're regulated by the SEC as well if they're registered as securities,

The Financial Industry Regulatory Authority (FINRA) also regulates variable and registered indexed annuities.

Agents or brokers selling annuities must hold a state-issued life insurance license as well as a securities license in the case of variable annuities. These agents or brokers typically earn a commission based on the notional value of the annuity contract.

Other Considerations

Surrender Period and Withdrawals

Annuities usually have a surrender period. Annuitants can't take withdrawals during this time without paying a surrender charge or fee. The surrender period may span several years.

Investors should consider their financial requirements during this time. It might be a good idea to evaluate whether they can afford to make requisite annuity payments if a major upcoming event such as a wedding is going to require significant amounts of cash.

Many insurance companies allow recipients to withdraw up to 10% of their account value without paying a surrender fee but you may end up paying a penalty if you withdraw more than that, even if the surrender period has already lapsed. Tax implications can also arise for withdrawals made before age 59½.

Some hard-up annuitants may opt to sell their annuity payments because of the potentially high cost of withdrawals. This is similar to borrowing against any other income stream. The annuitant receives a lump sum and gives up their right to some or all of their future annuity payments in exchange.

Income Riders

Contracts also have income riders that ensure a fixed income after the annuity kicks in. Investors should ask two questions when they consider income riders.

• At what age do they need the income? The payment terms and interest rates may vary depending on the duration of the annuity.
• What are the fees associated with the income rider? Some organizations offer them free of charge but most have fees associated with this service.

Individuals who invest in annuities can't outlive their income stream and this hedges longevity risk. The product is appropriate provided that the purchaser understands that they're trading a liquid lump sum for a guaranteed series of cash flows.

Some purchasers hope to cash out an annuity in the future at a profit but this isn't the intended use of the product.

Annuities in Workplace Retirement Plans

Annuities can be a beneficial part of a retirement plan but they're complex financial vehicles. Many employers don't offer them as part of an employee's retirement portfolio because of this.

The passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act signed into law by President Donald Trump in 2019 loosened the rules, however. Employers have more flexibility with selecting annuity providers and can include annuity options within 401(k) or 403(b) investment plans. Easing these rules may result in more investments made by qualified employees in annuities.

Types of Annuities

Annuities can be structured according to an array of details and factors such as the duration of time that payments from the annuity can be guaranteed to continue.

Annuities can be created so payments continue as long as either the annuitant or their spouse is alive if a survivorship benefit is elected. Annuities can also be structured to pay out funds for a fixed period such as 20 years regardless of how long the annuitant lives.

Immediate and Deferred Annuities

Annuities can begin to pay out immediately upon deposit of a lump sum or they can be structured for deferred benefits.

The immediate payment annuity begins paying when the annuitant deposits a lump sum. Deferred income annuities don't begin paying out after the initial investment. The client instead specifies an age at which they would like to begin receiving payments from the insurance company.

The annuity may or may not be able to recover some of the principal invested in the account depending on the type of annuity you choose. There's no refund of the principal in the case of a straight, lifetime payout. Payments simply continue until the beneficiary dies.

The recipient or their heirs may be entitled to a refund of any remaining principal if the annuity is set for a fixed period.

Fixed, Variable, and Indexed Annuities

Annuities can be structured generally as fixed, variable, or indexed:

• Fixed annuities provide a guaranteed minimum rate of interest and fixed periodic payments to the annuitant.
• Variable annuities allow the owner to receive larger future payments if investments held in the annuity fund do well or smaller payments if its investments do poorly. They provide less stable cash flow than a fixed annuity but they allow the annuitant to reap the benefits of strong returns from their fund's investments.
• Indexed annuities are fixed annuities that provide a return based on the performance of an equity index such as the S&P 500 index.

Variable annuities carry some market risk and the potential to lose principal but riders and features can be added to them, usually for an additional cost. This allows them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value.

Other riders can be purchased to add a death benefit to the agreement or to accelerate payouts if the annuity holder is diagnosed with a terminal illness. A cost-of-living rider will adjust the annual base cash flows for inflation to correspond with changes in the consumer price index (CPI).

Criticism of Annuities

One criticism of annuities is that they're illiquid. Deposits into annuity contracts are typically locked up for an extended period that is known as the surrender period. The annuitant incurs a penalty if all or part of that money is withdrawn.

These periods can last anywhere from two to more than 10 years depending on the product. Surrender fees can begin at 10% or more. The penalty typically declines annually over the surrender period.

Another criticism is that annuities are complex and costly. Individuals might buy an annuity without clearly understanding how they work or the costs involved. It's important to do your research to ensure that you understand all fees, charges, expenses, and potential penalties.

Annuities vs. Life Insurance

Life Insurance

Life insurance companies and investment companies are the two primary types of financial institutions that offer annuity products.

Annuities are a natural hedge for their insurance products for life insurance companies. Life insurance is bought to deal with mortality risk or the risk of dying prematurely. Policyholders pay an annual premium to the insurance company that will pay out a lump sum upon their deaths.

The insurer pays out the death benefit at a net loss to the company if the policyholder dies prematurely. Actuarial science and claims experience allow these insurance companies to price their policies so insurance purchasers will live long enough on average to allow the insurer to earn a profit.

The cash value inside permanent life insurance policies can be exchanged for an annuity product via a 1035 exchange without any tax implications in many cases.

Annuities

Annuities deal with longevity risk or the risk of outliving one's assets. The risk to the issuer of the annuity is that holders will survive to outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.

Examples of an Annuity

• A life insurance policy is an example of a fixed annuity into which an individual pays a fixed amount each month for a predetermined period, typically 59½ years, and receives a fixed income stream during their retirement years.
• An individual makes a single premium payment to an insurance company into an immediate annuity, such as $200,000. They then immediately receive regular payments such as $5,000 a month for a fixed time. The payout amount for immediate annuities depends on market conditions and interest rates.

The Bottom Line

An annuity is a financial contract between an annuity purchaser and an insurance company. The purchaser pays either a lump sum or regular payments over a period of time. The insurance company makes regular payments to the annuity owner in return, either immediately or beginning at some point in the future.

An annuity can be fixed, variable, or indexed to an equity index such as the S&P 500 index.