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

What Is an Annuity?

An annuity is an insurance contract issued and distributed by financial institutions and bought by individuals. An annuity requires the issuer to pay out a fixed or variable income stream to the purchaser, beginning either at once or at some time in the future.

People invest in, or purchase, annuities by making monthly premium payments or a lump-sum payment. 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 mainly used 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.

Since these assets may not be enough to sustain their standard of living, some investors may turn to an insurance company or other financial institution to purchase an annuity contract.

As such, these financial products are appropriate for investors, known as annuitants, who want stable, guaranteed retirement income.

Because invested cash is illiquid and subject to withdrawal penalties, it is not recommended that younger individuals or those with liquidity needs use this financial product.

Phases

An annuity has different phases. These are called:

• The accumulation phase, or the period of time when an annuity is being funded and before payouts begin. Money invested in the annuity grows on a tax-deferred basis during this stage.
• The annuitization phase, or the payout phase, which kicks in once payments to the investor commence.

Immediate vs. Deferred

Annuities can be immediate or deferred. Immediate annuities are often purchased by people of any age who have received a large lump sum of money, such as a settlement or lottery win, and who prefer to exchange it 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 are not securities and therefore are regulated by state insurance commissioners rather than the SEC.

Indexed annuities are normally regulated by a state insurance commissioner. If they are registered as securities, they are regulated by the SEC as well.

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

Agents or brokers selling annuities need to hold a state-issued life insurance license, and 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 cannot make withdrawals during this time, which may span several years, without paying a surrender charge or fee.

Investors must consider their financial requirements during this time period. For example, if a major event requires significant amounts of cash, such as a wedding, then it might be a good idea to evaluate whether the investor can afford to make requisite annuity payments.

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

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

Income Rider

Contracts also have an income rider that ensures a fixed income after the annuity kicks in. There are two questions that investors should ask when they consider income riders:

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

Individuals who invest in annuities cannot outlive their income stream, which hedges longevity risk. So long as the purchaser understands that they are trading a liquid lump sum for a guaranteed series of cash flows, the product is appropriate.

Some purchasers hope to cash out an annuity in the future at a profit. However, this is not the intended use of the product.

Annuities in Workplace Retirement Plans

Annuities can be a beneficial part of a retirement plan, but annuities are complex financial vehicles. Because of that complexity, many employers don't offer them as part of an employee's retirement portfolio.

However, 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 on how employers can select annuity providers and includes annuity options within 401(k) or 403(b) investment plans.

The easement of these rules may result in more investments 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.

As mentioned above, annuities can be created so that payments continue as long as either the annuitant or their spouse (if survivorship benefit is elected) is alive.

Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.

Immediate and Deferred Annuities

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

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

Depending on the type of annuity you choose, the annuity may or may not be able to recover some of the principal invested in the account. In the case of a straight, lifetime payout, there is no refund of the principal. Payments simply continue until the beneficiary dies.

If the annuity is set for a fixed period of time, the recipient may be entitled to a refund of any remaining principal–or their heirs, if the annuitant has deceased.

Fixed, Variable, and Indexed Annuities

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

• Fixed annuities provides 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 of the annuity fund do well and smaller payments if its investments do poorly. This means less stable cash flow than a fixed annuity but allows the annuitant to reap the benefits of strong returns from their fund's investments.
• Indexed annuities are fixed annuities that provide a return that's based on the performance of an equity index, such as the S&P 500 index.

While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to them—usually for an extra 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 may be purchased to add a death benefit to the agreement or to accelerate payouts if the annuity holder is diagnosed with a terminal illness. The cost of living rider is another common rider that will adjust the annual base cash flows for inflation based on changes in the consumer price index (CPI).

Criticism of Annuities

One criticism of annuities is that they are illiquid. Deposits into annuity contracts are typically locked up for an extended period of time, 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 particular product. Surrender fees can start out at 10% or more and the penalty typically declines annually over the surrender period.

Another criticism is that annuities are complex and costly. At times, individuals may buy an annuity without clearly knowing how they work or the costs involved. Be sure to do your research to understand all fees, charges, expenses, and potential penalties.

Annuities vs. Life Insurance

Life Insurance

Life insurance companies and investment companies are primarily the two types of financial institutions offering annuity products.

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

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

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

Annuities

Annuities, on the other hand, deal with longevity risk, or the risk of outliving one's assets. The risk to the issuer of the annuity is that annuity 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 by which an individual pays a fixed amount each month for a pre-determined time period (typically 59.5 years) and receives a fixed income stream during their retirement years.
• An immediate annuity involves an individual making a single premium payment, say $200,000, to an insurance company. They then receive regular payments immediately, for example $5,000 per month, for a fixed time period thereafter. 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. In return, the insurance company makes regular payments to the annuity owner, 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.