What is an Annuity and How Does It Work?


Living a long, fulfilling life is the goal, isn’t it? We all want to kick back, throw our feet up and enjoy our retirement after years of working hard. But what if we outlive our retirement savings? What happens when our income sources dry up, and our savings are depleted? This scenario is a genuine concern for many of us, but annuities can efficiently address it.

What is an annuity for retirement? An annuity is a surefire way to ensure you have a stream of income after retirement, lasting long after your 401(k) or personal IRA accounts run out. It’s relatively risk-free and comes with tax benefits and plenty of different options to suit your individual needs.

Unlike your 401(k) or IRA, contributions to an annuity are not capped, making this financial product an additional tax-deferred wealth-building avenue to ensure life is just as enjoyable as it’s supposed to be when we retire. In this article, we’re going to give you an in-depth answer to the questions, “what is an annuity and how does it work?” to help you achieve the retirement you desire and deserve. We’ll look at the benefits and disadvantages of annuities while addressing the many choices you can make during your annuity purchase, and we’re even going to dispel some popular annuity myths. By the end of this piece, you’ll have a good basic understanding of what an annuity is and how it works, and whether it is right for you.

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What is an Annuity?

What is an annuity in simple terms? An annuity is a financial product and method of saving that offers a guaranteed income stream for as long as you live. It is a form of insurance, with premiums that you can pay in installments or as one lump sum into an account. The funds are then dispersed to the annuitant (the person who receives the annuity) at an agreed-upon future time in a fixed income stream that you can use to live. There are several varying types of annuities that come with their benefits and drawbacks, giving you many options in planning for your retirement.

Consider an annuity an investment that can grow over time, giving you peace of mind in the days after you stop working. This financial product is an efficient, low-risk way to guarantee income once the paychecks stop rolling in. As annuities are generally funded with after-tax money, only the earnings you receive from annuity payouts will be taxed at regular income tax rates, but not until you start receiving the payouts. Over a long period of saving, that’s a lot of tax you won’t have to pay capital gains on as your money grows. Many people purchase an annuity to supplement or outrun the other income streams they’ve planned, and it is perfect for people who fear their retirement savings may not last as long as they need. It can also perform as an additional route to tax-deferred savings once your contributions to your other retirement savings accounts reach their limit.

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How Does an Annuity Work?

An annuity is considered a long-term investment contract that you can purchase from an insurance company to create a guaranteed income stream. During the accumulation phase, you can choose whether to invest in your annuity with a lump-sum or regular payments that will accumulate over time. The insurance company then invests your money with the intent to make it grow. At a set point in the future, often triggered by retirement, your payout phase will begin, and you will start to receive payouts from your investment at regular intervals, providing you with a safe and secure source of income to fund your retirement.

With some annuities, known as fixed annuities, your payments will remain static and guaranteed. Conversely, when you’ve purchased a variable annuity, your payouts may vary depending on how well investments you choose perform. Optionally, when you die, you can have your annuity payout to a beneficiary that you choose, which gives you an avenue to provide for your loved ones after you’re gone. An annuity is a low-risk and tax-deferred way to use your current income to fund your retirement and ensure that, in the event you do outlive your retirement savings, you can still make ends meet. While an annuity comes with fees and other costs, none of them outweigh the peace of mind you’ll get from knowing you don’t need to worry about money when you retire.

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The Phases of Annuities Explained

Annuities often come with two different phases: the accumulation phase and the payout phase. Let’s take a look at how these two phases differ.

The Accumulation Phase: When you choose to purchase an annuity from an insurance company, you will decide between funding your annuity with a lump-sum payment or through regular premiums. This period is called the accumulation phase, no matter which method you choose. The accumulation phase is the phase of the annuity during which your investment grows, as implied by the name. You’ll see the cash value of your annuity blossom during this phase close to what is the average return on an annuity, and this phase can last up to approximately 40 years.

The Payout phase: Once your accumulation phase ends, you’ll begin the payout phase. This phase can be a previously chosen time agreed upon in the contract. Some types of annuities can begin to payout immediately, but for many, deferring payouts until retirement is the most beneficial way to use this powerful savings tool. The payout phase is when you reap the benefits of your careful planning and investing. Payments are made to the annuitant during this phase, and they are often made monthly to become an income source in retirement. These payments are intended to last for your lifetime and, in the event you pass, can include a payout to your beneficiary.

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Types of Annuities

Although there are many more annuities, this form of investment is described most commonly with four different variables. They are:

  • Immediate
  • Deferred
  • Fixed
  • Variable

The type of annuity you choose will depend on when you plan to begin receiving your payments and how your annuity grows during the accumulation phase. Here are these annuity options explained:

Immediate annuity: An immediate annuity means you’ll get your payouts almost immediately after paying one lump sum into the policy. You can start to receive fixed payments from your annuity within a year of your initial investment. Immediate annuities are an excellent choice for those who need to guarantee a fixed income more so than they need their investment to be liquid.

Deferred annuity: As the name implies, a deferred annuity is designed so that the payout phase begins sometime in the future, like when you retire. During the accumulation phase of a deferred annuity, you can pay into your investment with a lump sum or through regular payments. Deferred annuities are a great way to supplement your retirement savings or ensure you still have an income after your savings run out.

Fixed annuity: This type of annuity guarantees a fixed interest rate on your payments into your investment. You’ll also receive guaranteed fixed payments during the payout phase. A fixed annuity can be beneficial when you’re looking for predictable returns on your investment and something with a little bit less risk than a variable annuity.

Variable annuity: A variable annuity allows you to choose investments that determine your annuity payout. Payments during the payout phase of your annuity will fluctuate depending on the performance of the investments you’ve chosen. This type of annuity can become quite complex, and your returns can be unpredictable. However variable annuities give you more opportunity to grow your investment using gains from your investments.

An immediate fixed annuity offers guaranteed fixed payments each month beginning right away. An immediate variable annuity will offer the investor immediate payouts that can fluctuate depending on the performance of the investments you’ve chosen. A deferred fixed annuity is set to payout fixed payments at a future date, and a deferred variable annuity will payout fluctuating payments in the future based on how well your chosen investments have performed.

In addition, there are also perpetuities, a specific and rare type of annuity. Annuities and perpetuities explained in simple terms — if an annuity is set up to never stop making payments, it is a perpetuity. But since most annuities will eventually stop making payments, not all annuities are perpetuities.

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Insurance-Based vs Investment-Based Annuities

As if annuities weren’t complex enough, they also break down into two more prominent categories. These categories are insurance-based annuities and investment-based annuities. While you will always purchase your annuity through an insurance provider, some annuities have the feel of an investment rather than an insurance policy.

Insurance-based annuities are just like the other forms of insurance you already know. You pay in with premiums, and your payouts are fixed and guaranteed by the insurance company. This type of annuity is not susceptible to losses based on the performance of stocks and other investments. However, investment-based annuities can see losses for this reason.

When you purchase a variable annuity, you can invest your contributions in different ways making your money susceptible to losses. Insurance-based annuities have payouts that are fixed based on what you paid into your annuity as well as your guaranteed interest rate. Investment-based annuities payouts are based on the performance of the investments you have selected as well as overall market performance. As such, investment-based annuities can see losses and are higher-risk than insurance-based annuities, but they can also grow greater than an insurance-based annuity.

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What is the Average Interest Rate on an Annuity?

Interest rates on annuities can be a little bit tricky because there are so many variables that go into them. To start, the insurance company you choose to purchase an annuity from will determine your interest rate based on several factors. These include the risk the insurance company is taking on, the amount you intend to invest in your annuity, what type of annuity you’ve chosen to purchase and how long your annuity is to be deferred or when you decide to begin the payout phase. Interest rates can vary for different annuities and different lengths of accumulation phases. On average, guaranteed annuity rates explained as fixed annuity rates fall between the 2.15% and 3.25% range. When you choose variable annuities, the insurance company assumes more risk on the investments it makes with your money, and they may choose to account for that with a higher interest rate. Our best advice is to compare and contrast the different interest rates offered by various insurance companies and choose the one that suits your growth model the best.

Interest rates can also fluctuate over time, and it can become quite frustrating to try and choose the right time to invest for the best interest rate. As with any investment, interest rates change, and you face the inability to predict where the market will go and whether or not interest rates will rise or fall. Instead, create a budget and goal for your annuity and try to find a good product that fits that model. Even with annuity rates explained, there’s no surefire way to predict rates so base your decisions on your goals, instead.

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Considerations for Annuities Explained in Simple Terms

Now that we have a basic answer to ‘what is an annuity and how does it work?’, there are a few more small considerations that can make the difference when planning to purchase your annuity. Let’s go over some of these factors you might want to consider:

Surrender period - The surrender period of an annuity is the period during which you cannot withdraw any funds from your annuity without incurring a surrender fee. The penalties for annuitants who withdraw funds from their annuities before the surrender period is over can be steep and are referred to as surrender fees. Your surrender period can be several years long, and you will find that the longer your annuity’s surrender period is, the better the other terms of your annuity, such as the interest rate.This gives annuitants the opportunity to capitalize on better terms by planning ahead for a longer surrender period. This won’t put you out if you’re prepared.

Income Rider - An income rider is an optional addition to your annuity that can protect your investment from poor investment performance. What results is a guaranteed fixed minimum lifelong income stream that can be relied upon and protected. This guarantee pays out no matter how long you live and how your investments are performing.

Annuity funds - What is an annuity fund? An annuity fund is the portfolio of investments on which the return on your annuity is based. The performance of the annuity fund into which your premiums have been invested will determine the amount of your payout. The premiums for fixed annuities are invested in annuity funds that are low-risk and low-growth, whereas variable annuity premiums are often invested in higher risk, higher reward annuity funds.

Fees - While ensuring a guaranteed income stream in retirement and offering returns on your investment, annuities also come with several fees. We’ve already discussed the surrender fee, which is incurred if you withdraw funds from your annuity before the surrender period is over. You can also expect to pay commissions on your annuities. Often, the commissions on annuities are calculated into the price, so you won’t be able to spot them in your contract. The insurance agent who helped you set up your investment will receive a commission based on a percentage of the value of your annuity. This commission will be paid out to the agent each year in most cases.

You’ll also discover that an annuity will incur some administrative fees. These fees can include:

    Annual Fee- You will most likely pay a yearly fee that covers the cost of the overall management of your annuity each year. This annual fee can be a flat rate, or a small percentage of the total value of your annuity.
    Mortality and expense risk- This fee is considered compensation to the insurer if the annuitant passes away before their life expectancy. This fee is, on average, 1.25% per year.
    Transfer charges- If you’ve chosen a variable annuity and want to switch annuity funds because you feel another may be performing better, you may incur a transfer charge to make that switch.
    Other fees you may incur - With your annuity there are contract fees, redemption fees, distribution charges and underwriting fees. It’s best to take a close look at your contract to get a handle on the overall cost of your annuity.
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Benefits of Annuities

The benefits of annuities are many and can change your retirement outlook altogether. Let’s take a quick look at some of the reasons people choose annuities:

    Guaranteed lifetime income stream- Annuities offer the annuitant the benefit of guaranteed income in their retirement for as long as they live. Steady income from an annuity can come in handy for retirees who worry they may outlive their retirement savings, and it can close the gap between what is recommended for retirement savings and what you may already have saved.
    Tax advantages- Your annuity earnings will be taxed as income rather than as capital gains, while the amount you invested will often not be taxed at all.
    Tax-deferred- Your annuity will often not be taxed until you start receiving your payouts which means it can grow faster than other investments.
    No contribution limits- Unlike your 401(k) or IRA, there is no contribution limit when it comes to annuities. You can contribute as much as you like during the accumulation phase.
    Death benefits- An annuitant can opt into a special rider that will allow some of your annuity to be paid out to a beneficiary of your choice upon your death.
    Investment options- With the ability to choose between variable, fixed, deferred and immediate annuities, you have complete control over how your money grows and for how long.
    No mandatory withdrawals- There is no requirement for annuitants to start taking payouts at any specific age. You can defer your distributions as long as you like.
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Drawbacks of Annuities

Like any form of investment, there are disadvantages to annuities as well. Here are some of the reasons people have chosen not to purchase an annuity:

    They can be challenging to understand- Annuities can be complex. Understanding what you will be paying and what fees to expect may not be as straightforward as you’d like. Choosing between the different types of annuities can also be confusing and make the decision-making process challenging.
    They can be costly- There can be a lot of fees, as we previously covered, associated with annuities, and these fees can be hard to fully comprehend. As such, getting a complete grasp on how much you should expect to pay in fees can be problematic. It’s a great practice to ensure you understand the cost of your annuity before signing your contract.
    Annuities are susceptible to inflation- What you put into your annuity may not have the same value when you take the payouts, and the growth that happened in between may not be very much more than the cost of inflation.
    Guarantees aren’t always 100%- Your annuity is tied to an insurance company, and insurance companies are fallible. They can fail, fold or declare bankruptcy, and annuities are not protected by the Federal Deposit Insurance Corporation. Ensure the longstanding record of the company you purchase your annuity from and check on the coverage provided by your state guaranty association.
    You may not make as much money on your annuity as you might be able to elsewhere- Investments come with risk, and part of that risk is that it may not grow as much as you want. Other forms of investment, such as mutual funds, may have a higher return for you but don’t offer the same guaranteed income stream for retirement.
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Common Annuity Myths

The complexity of annuities lends itself to the spread of many myths. There are a lot of common misconceptions about annuities. Let’s take a quick look at these annuity myths:

    Annuities are always expensive- While some annuities can be expensive, choosing a fixed annuity will save a great deal in fees as they do not come with annual fees as variable annuities might.
    Annuities always have high commissions- The commission you will pay on your annuity will depend on the type of annuity you’ve chosen. Fixed and immediate annuities tend to have much lower commissions than variable annuities.
    The insurance company pockets my investment when I die- Again, this may be true for some less common annuity contracts. Still, most annuities include a payout for a beneficiary of your choice when you die.
    Annuities are only for retirees- Annuities benefit retirees in many ways, it’s true, but anyone who wants to save money can benefit from an annuity. This financial product offers an additional method to build tax-deferred wealth when your 401(k) or IRA contributions hit their limits.
    Lifetime income can come from retirement savings- In reality, an annuity is the only form of guaranteed income that you can never outlive. Your retirement savings may not be able to do the same.
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Annuity Example

Annuities are complicated, and this article barely scratches the surface, but we always find that an easy example really helps wrap your mind around the concept. In that spirit, here’s a quick example of a simple annuity explained in simple terms to help you get a clearer picture:

Imagine paying a lump-sum premium to an insurance company of $100,000. That means your principal is $100,000, and any growth on that investment becomes your earnings. Once you give the principal to your insurance company, they will then invest that money in an annuity fund to grow over time. This period where your investment grows, and you’re not withdrawing any funds, is called the accumulation phase. When the payout phase begins, which often starts in retirement, you’ll start to receive monthly payments of, let’s say, $2,000 from your annuity, on which you will have to pay income tax. If this annuity is a variable annuity, your payments might fluctuate depending on the performance of the annuity fund. If your annuity is a fixed annuity, you will receive a fixed amount each month.

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Is an Annuity Right for Me?

From this article you have explored the questions what is an annuity and how does it work, and the next step is to discover if an annuity is right for you by considering your goals for investing your money in a product like this. Essentially, you are trading the liquidity of your investment money for the stability of steady income. If you anticipate you’ll need the money you invest and can’t afford to lose its liquidity, perhaps you should consider another form of investment. But if you’re prepared to set aside this money without touching it until a later date, then annuities might be suitable for you. Regardless of what is the best age to buy an annuity, remember that annuities are most commonly purchased by those wishing to catch up with retirement savings or close the gap between what they may need to retire and what they already have saved. Retirees benefit from the guaranteed income stream that results from an annuity. If you worry about how much you have saved for retirement, you might find an annuity can ease your worries. Additionally, those who have maxed out their contributions to their 401(k) or IRA can benefit from an annuity as it offers another tax-deferred saving method.

What is the minimum amount for an annuity, you might be wondering? Generally speaking, annuities begin at contributions of $25,000.

If you want to learn more about annuities and other retirement planning options, be sure to start your free account on Everdays, where you’ll find the assistance and guidance you need to plan for your future.

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