How do Annuities Work and What They Can Do For You

The world of annuities can be confusing, and they can sound like foreign jargon. Today, we’ll review what an annuity is, how they work, and when they are a good addition to your portfolio. You will leave with a better understanding if they are something you want to pursue.

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What is an Annuity?

An annuity is a contract between you and an insurance company. It is a financial product designed to provide a reliable stream of income. You can purchase an annuity by making a lump-sum payment or a series of payments to the insurance company.

In return, the insurer promises to make regular payments to you at a specified date. This can be immediately or several years in the future.

Similarities Between Different Types

When considering buying an annuity, there are several options. For some people, the numerous choices can be intimidating. If this is the case, consult with a qualified advisor.

The fundamentals of an annuity function the same. You pay the insurance company an amount of money. The insurance company then invests your money. Depending on the type of annuity, you (or your advisor) can determine which accounts to invest in or the insurance company will choose for you. Some policies will pay you back an income stream; others accumulate until you withdraw money via a lump sum or an income stream.

There are differences between the types of contracts that will be discussed later, but these are the fundamental characteristics of an annuity.

Types of Annuities

Some of the most common types of annuities include:

Fixed Annuities
Variable Annuities
Indexed Annuities
Immediate/Deferred Annuities

These annuities are insurance contracts that may serve as income streams later in life. They are commonly utilized in retirement planning to protect money against longevity risk (living longer than expected). Before discussing the different annuity types in detail, let’s review some important terms.

Annuity Terms

Understanding key terms is essential when researching annuities. Here are some important terms to know:

Premium

The payment made by the annuitant to purchase the annuity.

Accumulation Phase

This is the period during which you make payments into the annuity and your funds grow through investment earnings.

Distribution Phase

The distribution phase begins when you start receiving payments from the annuity.

Surrender Period

During a specified period, withdrawing funds from the annuity may result in surrender charges or penalties if you take more out than allowed. While many annuity companies allow the owner to withdraw 10% annually, always review the terms and consult a qualified advisor before taking any money out.

Death Benefit

A feature in some annuities that guarantees a minimum payout to the beneficiary upon the death of the annuitant.

Annuitant

The person whose life expectancy is used to calculate the annuity payments. This can be the same person as the annuity owner or a different individual.

How Do They Work?

There are many types of annuities, and they have differences in how they work. These differences are critical to tailoring the annuity to your needs. Below are the common types of annuities and how they work.

Fixed Annuities

These annuities offer a straightforward and predictable income. The insurer (insurance company) guarantees a fixed rate of return on your investment. The fixed rate remains constant for a specified period, typically ranging from five to 10 years.

This may be a good option for individuals who want a guaranteed fixed rate without any option to earn more money. They also offer tax-deferred growth, meaning that you won’t pay taxes on your payout until payments start. This allows your money to compound much better without taxes slowing growth.

One negative aspect is that fixed annuities often do not keep pace with inflation. This means your income won’t increase as quickly as food, groceries, gas, etc. Because their rate is guaranteed, they are commonly lower than other options, thus limiting your returns.

What a Fixed Annuity Can Do for You

These annuities can be a great option for those looking to supplement their retirement with a reliable income stream.

They are well-suited for those who prioritize stability and are willing to trade potential market gains for guaranteed returns.
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Variable Annuities

Variable annuities offer a blend of investment growth potential and personal choice. Unlike fixed annuities, where returns are guaranteed, variable annuities are not.

They allow you to invest your payments into subaccounts. These are commonly mutual funds investing in the following types of funds:

Aggressive growth
Growth
Balanced
Bond
Money markets

Because of the internal costs, it usually does not make sense to invest a variable annuity in fixed assets, including bonds and money markets.

The performance of these investments is reflected in the value of your annuity, meaning your returns can fluctuate based on market performance. These annuities are generally a better choice for individuals who want more return and are comfortable with market volatility and the potential to lose money if the markets drop.

What a Variable Annuity Can Do for You

These annuities may appeal to investors comfortable with market risk and seeking higher investment returns. In addition, they are also appropriate for investors who value the flexibility to customize their investment portfolio. Generally, younger investors with a longer time horizon are good candidates.

Indexed Annuities

These annuities offer a mix of growth potential and downside protection. Index annuities provide returns linked to the performance of an underlying stock market index, such as the S&P 500. As a safety net, they also offer a minimum guaranteed interest rate.

Compared to traditional fixed annuities, indexed annuities offer higher returns. In addition, they also provide a guaranteed interest rate to fall back on in case your investments do not perform as planned or desired.

On the other hand, indexed annuities generally have a five to 10-year surrender period. They, like other annuities are not considered to be liquid assets.. These annuities generally have participation caps that limit your growth to a certain degree, unlike variable annuities, which do not.

What an Indexed Annuity Can Do for You

Indexed annuities may be suitable for investors seeking a balance between growth potential and downside protection. They can appeal to those who want to participate in the stock market while safeguarding their principal investment. Many of these annuities guarantee that you will not lose money.

Immediate/Deferred Annuities

Immediate annuities offer a lifetime stream of guaranteed income. They can pay for a period of time, such as your life, a ten-year life, or a 20-year life (This means it would pay for your life plus the term, i.e., 10 or 20 years, whichever is longer). Immediate annuities offer a reliable stream of income that begins immediately, providing peace of mind.

Deferred annuities, on the other hand, offer income payments that are deferred until a later date, typically during retirement. With a deferred annuity, the insurer invests your contributions, allowing them to grow tax-deferred.

Both can vary depending on the type of annuity plan chosen (fixed, variable, or indexed), but each has different benefits in a portfolio depending on the goal.

What an Immediate Annuity Can Do for You

They can be valuable tools for retirees looking to secure a reliable income stream to cover essential expenses in retirement. In addition, they can be particularly suitable for individuals who prioritize financial stability and are afraid of outpacing their social security income.

What a Deferred Annuity Can Do for You

Deferred annuities can be valuable tools to plan for retirement by providing a reliable source of lifetime income.

They are particularly suitable for individuals who have maximized contributions to other retirement accounts, such as 401(k)s or IRAs.

Recap – “How do Annuities Work and What They Can Do For You”

There are many nuances and considerations when purchasing an annuity. For this reason, you must consult with a professional before buying an annuity or investment. Annuities offer a wide range of options to fit your specific needs. Because there are significant penalties to surrender an annuity, it is imperative to confirm you are purchasing the right annuity for your situation before you purchase one!

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