What Are Annuities and How Do They Work?
Put simply, an annuity is a contract that allows an investor to use present-day money to fund an interest/return-earning account they can use to pay themself during their retirement years in the future.
More specifically, annuities are financial instruments issued by insurance companies or financial institutions that provide their owners (annuitants) with income payments on a regular basis during a period known as the annuitization phase that usually coincides with retirement.
These income payments are funded with money invested by the holder of the annuity during an earlier period known as the accumulation phase. An individual can fund an annuity with a single, lump-sum contribution, or a series of smaller contributions over time. These contributions are often referred to as premiums.
The payments disbursed from an annuity can begin immediately or begin in the future on a specified date. These payments may end on a specific date, upon the death of their holder, or upon the death of the holder’s spouse, depending on the terms of the contract.
Annuities are binding contracts, and their sale is regulated both by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC).
What Are the Different Types of Annuities?
Annuities can fall into one of several categories based on two characteristics. First, annuities can be categorized by whether their accumulation phase begins immediately or in the future. They can be further categorized by whether their payment amounts are fixed and guaranteed, vary based on the market, or some combination of the two.
Immediate vs. Deferred Annuities
All annuities can be divided into one of two categories—immediate and deferred —based on when their periodic payments begin.
Immediate
Immediate annuities begin disbursing payments immediately, and for this reason, they are typically funded with a single, lump-sum payment. Immediate annuities are good for investors who need or want regular passive income payments beginning immediately.
Deferred
Deferred annuities, on the other hand, do not begin disbursing payments until a future date specified in the annuity contract. Because payments don’t begin immediately, deferred annuities can be funded either with a single, lump-sum payment or a series of smaller payments over time.
The period leading up to the payment phase, during which a deferred annuity is funded, is known as the accumulation period. Deferred annuities are good for investors who are not yet retired and/or do not have enough money to fund their entire annuity with a single payment.
Fixed vs. Variable vs. Indexed Annuities
All annuities can be further divided into one of three categories—fixed, variable, or indexed—depending on the degree to which their gains (and thus, payment amounts) are guaranteed.
Fixed
Fixed annuities are not tied to a portfolio or stock index, and they earn interest at a fixed rate of return (e.g., 2%) that is guaranteed by their contract before disbursing a series of equal payments during their annuitization phase.
In other words, fixed annuities guarantee modest returns that are not tied to the performance of a portfolio or financial market. Because of this, they are less risky than variable or indexed annuities, but they also don’t have any growth potential beyond the interest rate guaranteed by their contract.
Variable
The money contributed to a variable annuity is put into a portfolio whose performance depends on the market. In some cases, the money in a variable annuity is allocated in its entirety to a specific fund—often one that tracks a popular benchmark stock index like the S&P 500. In other cases, the holder of the annuity may allocate their funds to an array of financial securities of their choosing, including stocks, bonds, funds, and other instruments.
Variable annuities are so called because their rate of return is neither fixed nor guaranteed—instead, it varies based on the performance of the securities in the annuity’s portfolios. This means that, if the underlying portfolio performs well, a variable annuity can provide a much higher rate of return once payments begin than a fixed annuity. On the other hand, if the portfolio performs poorly, low rates of return or even losses can occur.
Note: Some variable annuities guarantee a return of premium, which means that all invested funds (minus fees) will be paid out during annuitization even if the underlying portfolio loses value.
Indexed
Indexed annuities share aspects of both fixed and variable annuities. Their performance is tied to the performance of one or more stock market indexes (e.g., the Russel 2,000), but they offer a guaranteed minimum return (e.g., 2%) regardless of the performance of the underlying index(es). This means that even if the annuity portfolio loses value, its holder will receive a modest return.
In exchange for this guaranteed return, the annuity portfolio’s gains are capped at a certain percentage. For example, if an indexed annuity’s returns were capped at 75%, and the underlying index(es) grew in value by 20%, the value of the annuity portfolio would only increase by 15%, with the remainder of the gains going to the annuity provider.
This sort of annuity is good for investors who are somewhat risk-averse but still want their retirement income to have some exposure to potential market growth.
Annuity Example: Deferred-Indexed
Let’s say an investor set up a deferred indexed annuity with an insurance company at age 45. If they planned to retire at 60, they might make regular, monthly contributions over the course of the next 15 years, which would constitute the annuity’s accumulation period.
Let’s say this annuity had a guaranteed minimum return of 3% and was invested in a fund that tracked the Wilshire 5,000 index with returns capped at 80%. If the Wilshire went up significantly in value, so would the investor’s contributions, although their gains would only amount to 4/5ths of the gains of the index fund itself. If the fund went down in value, however, the investor’s funds would still earn the 3% minimum interest guaranteed by their indexed annuity contract.
How Safe/Risky Are Annuities?
How safe or risky any annuity is depends on the specific terms of its contract. Fixed annuities are the safest, as returns are guaranteed at the rate specified in the contract. That being said, their upside potential is also capped at this rate, so depending on the rate of inflation, the fees paid to the annuity provider, and the length of the accumulation period, the funds paid out during annuitization may actually be worth less than the funds paid in originally.
Variable annuities are riskier but have higher upside potential, as their performance depends on the performance of an underlying portfolio, which could go up or down in value depending on the market and the portfolio's composition. That being said, variable annuities with a guaranteed return of premium have their risk capped at the rate of inflation plus any fees paid to the annuity provider.
Indexed annuities balance the potential upside of variable annuities with the guaranteed minimum return of fixed annuities, making them a reasonable option for investors seeking to balance retirement income security with growth potential.
What Fees Are Associated With Annuities?
Annuities are subject to a number of fees, which are outlined in their contracts. Most annuities are subject to commission fees, which are paid to the salespeople who issue them. These can vary from around 1% to around 8% depending on the annuity type. Annuities may also charge underwriting fees, management and administrative fees, rider fees for contract amendments/additions, and early withdrawal fees.
How Are Annuities Taxed?
Annuities are typically tax-deferred (like a 401k), meaning contributions are not taxed during the accumulation phase. Instead, payouts are taxed at the same rate as normal income during the annuitization phase. This means that all contributions are allowed to earn interest/returns pre-tax.
Because the annuitization phase typically coincides with retirement, annuity holders often fall into a lower tax bracket at this stage, allowing them to keep a higher percentage of their funds than they would have had they been taxed as contributions.
How Are Annuities Set Up?
Annuities can be set up through certain insurance companies, certain financial institutions, and, since the passing of the Secure Act in December of 2019, through certain employer-provided 401k retirement plans.
What Happens to an Annuity When Its Owner Dies?
This depends on the terms of the annuity’s contract. Some annuities stop payments when the holder dies, while others divert payments to the late contract holder’s spouse or family. What happens to an annuity’s remaining funds when the contract holder dies can be decided by the each investor when their contract is created.
Should You Invest in an Annuity?
Anyone considering using an annuity should read any contracts they are considering carefully and compare options between multiple companies before signing a contract.
In many cases, contributing to an employer-facilitated 401k account or simply investing one’s own savings into a well-diversified portfolio can result in similar gains and fewer fees. That being said, annuities do effectively lock funds away until annuitization, so they can be an effective tool for those who have trouble setting money aside regularly for retirement.
Consulting with a financial advisor about your specific situation, goals, and timeline before investing in an annuity or other long-term financial instrument is always advisable.
