What Are Annuities and How Do They Work?

Will your retirement savings last your lifetime? Why not consider annuities? An annuity is a financial product that offers the ability to receive a series of guaranteed income over time. In this situation, you enter into a contract with an insurance company by paying either a lump sum or a series of premiums. In return, the insurer commits to paying you regularly, either now or in the future. 

An annuity may be a good retirement strategy to help ensure a continuous flow of income in your post-retirement years. It may also be an option for employees whose employers don’t offer pensions.

One of the most significant benefits of an annuity is that it lets you convert a portion of your money into a guaranteed income for the remainder of your life. This article delves into how annuities work, the types of annuities, and some of the benefits of this product. Let’s dive in.

How Annuities Work

You can buy annuities from insurance companies, banks, and brokerage firms. Below is a breakdown of how annuities work.

Paying into the Annuity

With an annuity, you can pay through regular premium payments or a one-time payment depending on the specific annuity you select.

Growth Potential

The annuity value has the potential to grow in a variety of ways, from a stated interest rate to interest that could vary by market conditions (variable annuities) or based on changes to an external market index (fixed index annuities). It’s worth noting that your money can grow tax-deferred so you don’t pay taxes on the growth until you make a withdrawal. At that time, the money is taxed as ordinary income (a 10% IRS penalty may apply to withdrawals before age 59-1/2).

Payout Phase

You receive your annuity according to your contract terms. This might be monthly, quarterly, or yearly. Payments from the annuity will generally consist of interest plus fees subtracted from the  growth within the annuity. You can opt for a lifetime of payment or turn your annuity into a protected income for a fixed payment period.

Types of Annuities

There are several types of annuities, and they share some key features. For example, all annuities involve fees and charges including surrender penalties for early withdrawals. They are long term vehicles designed for retirement income and may offer a death benefit for your beneficiaries. Let’s take a look at the common ones.

• Immediate annuity: Payout begins as soon as you make a lump-sum payment, generally within the first year. 

• Deferred annuity: Payout starts on a set future date, often after retirement. 

• Fixed annuity: The annuity earns interest at a stated rate guaranteed by the issuing company. The insurance company assumes any investment risk and interest rates and annuity payments are fixed.                                                                                                      

• Variable annuity: This annuity offers several investment options called subaccounts which invest in vehicles such as bonds, mutual funds, and stocks. Variable annuities have growth potential, although returns vary with the performance of underlying investments and you can lose money due to market declines. Variable annuities may involve greater fees because they are both investments and insurance products. 

• Fixed Indexed annuity: A fixed indexed annuity offers the potential for interest credits tied to the performance of an external market index, such as the S&P 500, while never being invested in the market or exposed to market losses. Interest is capped by the issuing company, and you may earn 0% in any given year, but you will not lose value due to market losses.

• Qualified longevity annuity contract: QLAC lets you convert a portion of your retirement account, like a 401(k) or IRA, into a steady income stream. This income stream must start by the age of 85. The money used to buy the QLAC is exempt from the required minimum distribution (RMD) calculations until age 85.

Pros and Cons of Annuities

The following are some common pros and cons of annuities.

Pros

• Guaranteed income stream: One of the greatest benefits of annuities is that they offer steady and guaranteed income to help you enjoy a more financially stable retirement. 

• Customizable: You can buy different types of annuities for specific situations. For instance, some annuities create an immediate income stream, while others assist in building cash value by deferring income until later.

• Tax-deferral: Annuities can grow tax deferred, which means that taxes aren't due until annuity payments begin, which is when some people anticipate being in a reduced tax band in retirement.

Cons

• Fees and commissions: All annuities involve fees and charges, and some are higher than others. You need to weigh the costs associated with the annuity against its expected benefits to make the right purchasing decision for your situation.

• Restricted funds access: Annuities are long term retirement vehicles and involve surrender penalties for withdrawals taken early. Many annuities do, however, offer access to a portion of your money, typically up to 10%, without incurring surrender penalties. 

• Risk of inflation: Annuities provide an immediate or future payment guarantee at a predetermined level. The purchasing power of those fixed payments could decline if inflation increases.

Who Should Consider An Annuity?

You may be a candidate for annuity if:

• You’re worried about outliving your savings: Some retirees are concerned that their IRA, 401(k), or other investments may not last their lifetime. Even after the initial premiums paid into the contract are depleted, lifetime income annuities may continue to pay out for as long as the annuitant is alive.

• You want to help protect a portion of your retirement income: Look into annuities if you're getting close to retirement and want help safeguard your retirement income or if you just want to keep some of your savings out of the market and away from downside risk.

• You’re risk-averse: If you find the volatility of the stock market unsettling, annuities may be an option for a portion of your funds. Fixed annuities offer guaranteed interest rates with tax-deferred growth.

• You’ve maxed out your retirement contributions: If you max out your IRA and 401(k) contributions, you may be a candidate for an annuity as an alternate place to save for retirement. It may also be appropriate for those in high tax brackets but intend to delay tax payments on any growth. 

• You would like to leave a financial legacy: Imagine passing down your assets and structured payments to your beneficiaries. Some annuities enable beneficiaries to receive structured or lump-sum payouts. Death benefit riders can guarantee benefits for estate planning or the continuation of spousal income.

Final Thoughts

Research shows that in the second quarter of 2023, the expected total value of retirement investments in annuities was 2.29 trillion USD, up from 2.16 trillion USD the previous year. This implies that more people are purchasing annuities.

Before investing in annuities, it’s important to remember that these are long-term investment vehicles whose value keeps fluctuating. Annuities are complex products. That’s why it's advisable to talk to a qualified financial and insurance professional for guidance.

Investment advisory services offered through CreativeOne Wealth, LLC, a registered investment adviser. CreativeOne Wealth and Pioneer Wealth Management are unaffiliated entities. Licensed insurance professional. We are not affiliated with any government agency, and do not provide tax or legal advice.

Investing involves risk, including possible loss of principal. Investment advisory services are provided in accordance with a fiduciary duty of care and loyalty that includes putting your interests first and disclosing conflicts. Insurance services have a best interest standard which requires recommendations to be in your best interest. Advisors may receive commission for the sale of insurance and annuity products.

Annuities are designed to meet long-term needs for retirement income, and they are not suitable for everyone. They provide guarantees of principal and credited interest, and a death benefit for beneficiaries.  For fixed indexed annuities, the interest credited on your contract may be affected by the performance of an external index. However, your contract does not directly participate in the index or any equity or fixed interest investments. You are not buying shares in an index. All annuities are subject to surrender charges and may have applicable fees. Guarantees are backed by the financial strength of the issuing company. Annuities are not bank or FDIC insured. Income riders are generally optional and have an additional associated cost. Product and feature availability may vary by state.