What Is an Annuity and How Does it Work?

Annuities can be a valuable tool for retirement planning. Learn how they work and the different types available to see if they are right for you.

As retirement approaches, many individuals begin to think about how they can ensure a steady stream of income during their golden years. One popular option to consider is investing in annuities. With the potential for guaranteed payments, tax-deferred growth and flexible payment options, annuities can be a valuable asset in a well-rounded retirement portfolio. Learn more about annuities and how they work in this informative guide, and find out if an annuity is the right choice for your retirement planning needs.

What Is an Annuity?

An annuity is a financial product that provides a fixed stream of income for the future. It is essentially an insurance contract between an individual and an insurance company in which the individual makes regular payments (either upfront or over time) in exchange for guaranteed future payments.

Annuities are commonly used for retirement, as they help to ensure funds in the event your savings run out, but some annuity options offer pay-outs in addition to your current income. Annuities are a unique type of investment tool that can be used to create additional income streams. You can choose from multiple different types of annuities, each of which offers their own benefits and drawbacks.

How Annuities Work

When you sign onto an annuity, over time, you’ll pay a certain amount of money into an annuity fund. In exchange, you’ll receive a lump sum back in the future, or you are paid a stream of income. In some cases, you may have the option to pay a lump sum upfront when you sign onto your annuity contract. The type of payout you receive is determined by the type of annuity you purchase. Annuities are essentially an insurance product and are distributed by financial institutions.

You can use annuities as another source of cash flow and help pay for your standard of living in case you outlive your assets. While the idea of an annuity seems basic, it can become more complicated depending on the way that your contract is set up. However, annuities can be used as an investment tool, which can make investing for retirement a lot less complex when compared to other types of retirement savings vehicles like Individual Retirement Account (IRA) or 401(k).

Annuities go through different periods. These are called:

• Accumulation period: This initial phase marks the period during which the annuity is being funded with your payments before payouts begin. During this period, the money you invest is growing on a tax-deferred basis.
• Annuitization period: This period refers to the time frame over which an annuity contract is paid out to the annuitant in regular installments, typically in retirement.

Annuities have what is called a surrender period, which is a period of time during which withdrawals made are subject to a surrender fee. The surrender period can last years, so you should consider this feature and look at other financial commitments you have before choosing which type of annuity you wish to purchase.

The use of an annuity is not to be cashed out in the future for a profit. Annuities are for trading a lump sum for guaranteed cash flow payments in the future. This is why annuities may not be the best option for some people, especially those who doesn't want a long period of time when investing.

Types of Annuities

Understanding the different types of annuities can help individuals make informed decisions when planning for their financial future. Let's delve into the various options available for annuities.

Immediate Fixed-Income Annuities

Immediate fixed-income annuities are fixed annuities that have a set interest rate. These annuities require you to pay a set amount once in exchange for a stream of income over a certain period of time. The stream of income could last your entire life, or have a limit, depending on what your specific contract specifies. This type of annuity’s payments typically begin immediately after the deposit is made.

Deferred Income Annuities

Deferred income annuities are also considered a fixed annuity. You pay a lump sum and then receive the stream of income over time. However, the stream of income is deferred for a period of time, which means you don’t immediately begin receiving your payments. This period of time can be months or even years long. During the accumulation period, the interest of your annuity will grow as you make payments into your account. In some cases, you are able to make more payments during this accumulation period in order to grow your future stream of income.

Variable Annuities

A more complicated type of annuity is the variable annuity as it is considered more of an investment. You decide where you want your annuity payments to be directed to, and the amount you are paid in the future is determined by your payments and the return on the investment. Fees and other expenses charged by the annuity provider reduce your future income. This type of annuity carries higher risk because while it could become a higher payout, you could also end up with a lower income during retirement than you hoped.

Indexed Annuities

This type of annuity is a combination of variable and fixed annuities. With indexed annuities you get a base income that is guaranteed; however, part of the stream of income is also determined by an index’s performance, such as the S&P 500. While this type of annuity gets some protection from major market drops, the trade-off is a lower benefit when the market is doing well.

Annuity Payout Options

How does an annuity pay out? There are several different payout options available, each with its own set of benefits and considerations.

• Lifetime income: The annuitant will receive regular payments for their lifetime, regardless of how long they live. This option offers a guaranteed income stream throughout the annuitant's life, providing financial security in retirement.
• Joint and survivor income: This allows the annuitant to receive income for the rest of their life, with payments continuing to a named beneficiary (usually a spouse) after the annuitant's death. This can be a good choice for couples who want to ensure that both spouses have a guaranteed income stream for their lifetimes.
• Fixed period: The annuitant will receive payments for a specified number of years, regardless of whether they are alive or deceased. This can be a good option for individuals who want to ensure that their beneficiaries receive fixed income for a certain period of time.
• Lump sum: Some annuity contracts allow the annuitant to receive a one-time lump sum payment instead of regular income payments. This can be beneficial for individuals who need a large sum of money for a specific purpose, such as buying a home or paying off debt.
• Systematic withdrawal: The annuitant has the option to receive regular payments of a specific amount for a set period. This provides flexibility in how payments are received and can be adjusted as financial needs change.

When choosing an annuity payout option, it is important to consider your financial goals, risk tolerance and long-term financial needs. It is also a good idea to consult with a financial advisor to determine which option is best for your individual circumstances and ensure that your annuity provides a stable and reliable source of income for years to come.

Benefits of Annuities

Annuities offer a range of benefits that make them a valuable investment option for individuals seeking financial security in the long term.

• Guaranteed Income Stream: One of the main reasons for purchasing an annuity is to ease your mind for retirement. An annuity guarantees a stream of income during your retirement, so you don’t have to worry about your savings running out.
• Income supplementation: If you plan to purchase an annuity that begins its income immediately — such as an immediate fixed-income annuity — then your annuity becomes a stream of money that is supplemental to your current income if you’re not retired yet. You can go on to invest this money if you’re currently in a comfortable financial situation and turn to the annuity as a supplemental income if your finances change.
• Simplicity: While some aspects of annuities can be complicated depending on the type you purchase, it’s still a simpler investment option than many other options. The simplicity of making a lump sum, or payments over time, then receiving a stream of income makes it an easier investment than most.

Drawbacks of Annuities

While annuities can offer a variety of benefits, it is important to consider these drawbacks as well.

• Fees: All annuities come with a number of fees that can start to add up quickly. These fees could include insurance charges, rider fees, contract fees, surrender charges, investment management fees and many more additional charges that cut into the total value that you get from your annuity. The fees you’re charged depend on the insurance company and the type of annuity you purchase.
• Low returns: When you purchase an annuity, you have to know that you may be giving up some other investments that may have higher returns. While returns on annuities can be good, you might still be able to get a higher payout when investing elsewhere.

Compare Annuity Options

Beginning your search for the right annuity provider starts with reviewing some of the best-known market options. Benzinga offers insights and reviews on the following annuity providers — you may want to consider beginning your search using the links below.  

How Are You Taxed on an Annuity?

Annuity payments are typically taxed as ordinary income when received. This means that you will have to pay income tax on the payments at your regular tax rate. Additionally, if the annuity was funded with pre-tax dollars, you may also be subject to additional taxes or penalties. It is important to consult with a tax professional to fully understand the tax implications of an annuity.

Annuities vs. Life Insurance

Annuities and life insurance are both financial products that offer security, but they serve different purposes. Annuities provide a steady income stream during retirement, while life insurance provides financial protection for loved ones in the event of the policyholder's death. It's important to consider your financial needs and goals before deciding which product is right for you, and consulting with a financial advisor can help you make an informed decision.

Should You Consider an Annuity?

The primary benefit of investing in an annuity is guaranteed, consistent payments, which can act as a major source of peace of mind during your retirement period. However, you should know that investing in an annuity also comes with the opportunity cost of other investments, which can produce greater returns over longer periods of time. Consider consulting a financial professional to learn more about how an annuity will impact your unique household finances and retirement timeline.

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