What Is an Annuity and How Does it Work?

 Everybody knows about a checking account, advantages of a savings account or how to buy a certificate of deposit. However, if you ask them what an annuity is, you will probably get some shrugs. Annuities are often misunderstood, so in this article we’re going to cover the basics of how an annuity works, how to buy an annuity, and whether an annuity is right for you.

What is an Annuity?

An annuity is an insurance contract that provides a guaranteed stream of income for a specified amount of time or life. A guaranteed steady stream of income is the holy grail of financial planning, so why isn’t everyone flooding insurance companies to buy an annuity? Because any type of “guarantee” comes at a high cost and not everyone will need a guarantee.

A financially savvy person saving responsibly for his/her retirement might be able to self-insure. On top of that, annuities are complex and there are different varieties of annuities with hundreds of options, riders, disclaimers, footnotes and contingencies.

Different Types of Annuities

There are two basic types of annuities – immediate and deferred.

1. Immediate annuity – If you need a guaranteed stream of income right away, you can convert a lump sum to an immediate annuity that pays out monthly, quarterly or annually. You can opt to get payments for a fixed number of years or until you die. Yes, if you have retirement savings, you can start drawing down from that but there is always the risk of running out of money if the money is no longer growing with inflation.
2. Deferred annuity – If you are years away from your retirement and want to make sure you have a guaranteed income source in retirement, you can get a deferred annuity. The cash you invest grows tax deferred within the annuity (similar to your 401k) to receive payments at a later date.

Each of these can have multiple options – single premium, flexible premium, fixed annuity, variable annuity, life income annuity, joint annuity, equity-indexed annuity, to name a few.

Annuity Options

Purchasing an annuity isn’t as easy as deciding whether or not you simply want an immediate annuity or deferred annuity. Below are a few of the options you need to consider:

• Single premium – You buy an annuity using a lump sum.
• Flexible premium – you pay multiple premiums to the company.
• Fixed – Your money will earn a fixed interest rate set by the insurance company. When you begin receiving income, a fixed payment is guaranteed.
• Variable – Your money will be split into sub-accounts depending on your risk level, and be invested in stocks, bonds or other investments. The annuity pays a minimum income which could go up depending on performance, but the downside is these typically have substantially higher fees than mutual funds.
• Equity-Indexed – A variation of a fixed annuity where the interest rate is based on an outside index, such as a stock market index. Similar to variable annuity this product pays a minimum rate which might go up if the index performs better.
• Life income – You receive income as long as you live, even if payments exceed the amount of money you put into the annuity. If you buy an installment refund rider your beneficiaries will continue to receive payments even after you die until the total amount paid to you and your beneficiaries equals the premium. If you didn’t buy any rider, the insurance company will keep the money.
• Joint and life income – Provides income as long as you or the survivor live.

The Advantages of an Annuity

Annuities offer two types of benefits – tax-related and investment-related.

• The “sleep at night” factor: Average life expectancy in the U.S. is getting longer and longer. So, it’s no surprise that a top worry for people saving for retirement is that they might outlive their savings. Annuities are supposed to be a solution to that. With the right annuity, you can get a guaranteed stream of income, however long you live. Sometimes, people feel that simply having the peace of mind that they’ll always have a source of income makes annuities worth a look.
• Control risks: A variable annuity will let you take risks (via the underlying investment options) while giving you some control of the outcome (via the option of guaranteed minimum income). So, in a way, it lets you take financial risk and reduce it at the same time. For example, if you get a variable deferred annuity with minimum income, you can get the peace of mind that you will receive $x no matter how you invest the money in the annuity. If your annuity’s performance is great you will receive $y (>$x) for life. If the performance is poor, you will still receive the $x promised for life.
• Tax deferral: When you buy a deferred annuity, the earnings are tax-deferred, which means that you don’t pay tax on the growth of the investments until you start making withdrawals. If you’re in a high tax bracket now and expect to be in a low tax bracket at retirement, this can add a good chunk of money to your nest egg.
• Unlimited contributions – Unlike tax-advantaged accounts like IRAs or 401ks, there is no yearly contribution limit for an annuity. Qualified annuities allow you to sock away a large amount of cash and defer paying taxes. This can be especially beneficial if you are nearing retirement and have to catch up, or if you’re in a high tax bracket now but who expect to be in a lower tax bracket during retirement. And yes, if you hit the megamillions jackpot, you can invest that in an annuity and postpone the day Uncle Sam knocks on your door.

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Disadvantages of an Annuity

The major disadvantage of an annuity is that they are too costly for the benefits they provide. Below is a laundry list of costs that come with annuities.

• Mortality and expense risk fee (M&E fee): This is the major fee (can be anywhere from .5 – 1.5% of the policy value per year) which pays for the carrier to assume the risk that you and other annuity owners will live longer than expected.
• Annual contract fee: This fee might be a fixed dollar amount or an expense ratio. For high value annuities, this fee might be waived.
• Investment management fees: This is similar to the management fees you would pay an investment manager if he manages your investments. Variable annuities can have a lot of subaccounts, each of them holding a different investment. Similar to mutual funds, if the investments are index funds or exchange trade funds, the fees are lower. If they are actively managed funds, the fees can be very high. You will also pay the underlying fund expense ratio.
• Optional rider fees: You can add a lot of riders to your annuity like guaranteed living benefits for deferred variable annuity or long-term care insurance. Each of these riders will cost money.
• Commissions: When you buy an annuity through a broker, you’ll pay a commission. The commissions can range from 1% to 10% depending on the product (the longer the surrender period, the higher the commission). Even if the broker tells you that there are no fees, read the prospectus thoroughly, it might be built into the annuity. Sometimes, this is included in the M&E fees, sometimes it’s not.
• Withdrawal or Surrender charges: Penalty/fees for taking out part or all of the cash value of the annuity prior to a specified date. If you invest the money and want to take it out before this date, you might lose a major portion of your money.

In addition to the expense, here are some other disadvantages of annuities:

• You already own an income annuity – It’s called Social Security. If you’ve worked and paid payroll taxes in the United States for at least ten years (or forty quarters) you own an annuity from the Social Security Administration. If you’re still in the workforce, you own a deferred annuity. If you’re 65 or older, you can start taking payments immediately, which means you own an immediate annuity.
• Reduced liquidity – Annuities are meant to provide a guarantee, and for that guarantee you are giving up the access to your money for a certain period of time. The more generous the guarantee, the longer you’ll relinquish access. If you want to get your hands on the money, you’ll find out that annuity contracts have a lot of fees and penalties that might shrink your investments drastically.
• Annuity taxation – When you start taking payments from your annuity, those payments are taxed as ordinary income. In contrast, if you owned mutual funds or stocks, you’d pay the long-term capital gains rate on the earnings. The current ordinary income tax rate ranges from 10% to 37% depending on your income, whereas the long-term capital gains tax rate are 0%, 15%, or 20% depending on your taxable income and filing status. This can make a huge difference!