How Do Annuities Work?

Although they come in countless varieties, most annuities work as insurance against outliving your savings. Insurance companies and others that sell annuities are offering a guaranteed income stream to help fund your needs for the rest of your life or a preset period of time.

Written By : Elaine Silvestrini
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Annuities are different from and difficult to compare to other kinds of investments. Because of this, it may be easier to consider annuities a purchase than a traditional investment.

But what are you purchasing? You’re purchasing a reliable, steady stream of payments to support your financial needs for the rest of your life or for a pre-determined number of years.

Pro Tip
Because they are contracts, annuities can also be adapted to meet your specific needs and fit your comfort with different levels of risk.

You can get a fixed annuity in which the payments are spelled out exactly ahead of time in the contract. Or you can get a variable annuity with the potential for higher – or lower – payments, depending on the performance of a traditional investment portfolio.

Annuities are not for everyone. But if you’re nearing retirement and need to ensure you can pay your living expenses after you’ve stopped working, you should consider if an annuity is right for you.

Annuities Explained

An annuity is a contract between you and an insurance company in which you purchase a stream of payments to yourself over time.

There are a number of annuity types, allowing you to find which one fits your needs and comfort level. You can also purchase a variety of contract provisions, known as riders, to modify the annuity to further customize it.

Learn More About Annuities

How Do Fixed Annuities Work?

Fixed annuities provide periodic payments in amounts that are specifically agreed upon in the contract. If your contract says the payout rate is 5 percent on a $100,000 annuity, for example, then you will receive $5,000 worth of payments every year covered by the contract.

how Fixed Annuities work
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Break down of how Fixed Annuities work

How Does a Variable Annuity Work?

Variable annuities have payout rates that vary, depending on the performance of an investment portfolio. The amount you receive in payments depends on how much money the portfolio gains or loses. This is riskier, but also has the potential of paying you more.

how Variable Annuities work
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Break down of how Variable Annuities work

Are Annuities a Good Idea?

Whether annuities are a good idea depends on your circumstances, your needs and whether the particular annuity type is a good fit.

If you already have a healthy pension or another source of income sufficient to support your everyday needs in retirement, you may not need an annuity.

If you don’t have a guaranteed stream of retirement income, you should consider investing in annuities. They’re a good source of lifetime income.

On the other hand, if you don’t have enough savings to buy an annuity and have enough available for unexpected expenses, you should be cautious about purchasing annuities. That’s because you won’t have access to the money you used to buy the annuity. Generally, it’s best to ensure you have enough accessible savings for potential needs, such as medical bills.

Learn More About Annuity Types

Who Should Consider Annuities?

If you’re healthy and likely to live a long life, an annuity can be good insurance against outliving your savings.

If you’re unhealthy, annuities might not work for you. This is especially true if you don’t expect to live long and are unlikely to outlive your savings. You also may need access to your savings to pay medical bills.

If you’re younger, you’re likely to be able to invest in stocks and other offerings that are more risky because you have time to recover losses in the long run. If you’re older, the safety and predictability of annuities are likely to be more suited to your needs.

Are Annuities Safe?

By and large, annuities are a safe investment. However, it’s important with annuities to purchase them from highly rated, well-established insurance and financial services companies with good reputations.

That’s partly because, unlike certificates of deposit, annuities are not insured by the Federal Deposit Insurance Corporation.

Pro Tip
All states have guaranty associations that insure at least partially against the failure of annuity providers.

The amount of protection varies from state to state. States also regulate insurance companies, requiring them to meet financial standards intended to keep them solvent.

All insurers that sell annuities must belong to the guaranty associations in the states where they operate. For information about your state’s guaranty association, you can find links to all state associations on the website of the National Organization of Life & Health Insurance Guaranty Associations.

Ways Annuity Investments Are Safer

In two states — Florida and Texas — your money in an annuity is protected from creditors and frivolous lawsuits. Most other states provide limited protections. And likewise, in federal bankruptcy cases, the law provides a small amount of protection of annuity assets from creditors.

Pro Tip
Investing in a fixed annuity, as opposed to the stock market, protects your money from the overall economic threats that can diminish your nest egg in the short term, said Wenliang Hou, senior research advisor at the Center for Retirement Research at Boston College.

This is especially important for older people depending on their savings who cannot afford to ride out a down market.

Annuity vs 401(k)

Annuities and 401(k) plans are retirement accounts with some significant differences.

Here are some of those differences:
Availability
401(k) plans are available only to individuals whose employers offer them. Annuities are not employer-sponsored and can be purchased by anyone.
Contribution limits
There are contribution limits for 401(k) accounts, but none for annuities. As of 2018, the 401(k) limits were $18,500 per year until age 50 and $24,500 after that.
Tax deferrals
Both annuities and 401(k) accounts provide the ability to defer paying taxes on earnings until the money is withdrawn. However, contributions to 401(k) accounts may be deducted from your taxes in the years in which they are made. Contributions to annuities may not be tax deducted.
Taxes on withdrawals
Because of that 401(k) deduction, withdrawals from those accounts are taxable in their entirety. Only the portions of annuity withdrawals that represent earnings are taxable.

Some people chose to roll all or part of their 401(k) savings into annuities as a means of providing a stream of income to fund retirement.

How Much Do You Need to Start an Annuity?

Each annuity has different fees and restrictions. Different companies set different investing requirements.

But in deciding whether you have enough money to invest in an annuity, it may be best to consider what kind of return your annuity purchase might bring.

Let’s take a fixed, immediate annuity with a 5 percent payout rate as an example. That means, each year, you will receive payments totaling an amount equivalent to 5 percent of your investment.

Fixed Annuity Purchase at 5% Yearly Payment Monthly Payment
$1,000 $50 $4.71
$5,000 $250 $20.83
$10,000 $500 $41.66
$25,000 $1,250 $41.66
$50,000 $2,500 $208.33
$100,000 $5,000 $416.67
$500,000 $25,000 $2,083.33

You should decide if the money you can spend on an annuity will bring you enough income to make having the annuity worthwhile.

8 Cited Research Articles

  1. Rodeck, D. (n.d.). What Is the Difference Between Annuities & 401(k) Plans? Retrieved from https://budgeting.thenest.com/difference-between-annuities-401k-plans-25970.html
  2. Money. (n.d.) Should I Roll My 401(k) Into an Annuity? Retrieved from http://time.com/money/collection-post/2982267/should-i-roll-my-401k-into-an-annuity/
  3. Cussen, M.P. (n.d.). Should Your 401(k) Be In An Annuity? Retrieved from https://www.investopedia.com/articles/retirement/10/401k-annuity.asp
  4. Marangian, S. 2016, December 21). How Safe Is Your Annuity? Retrieved from https://www.fool.com/retirement/2016/12/21/how-safe-is-your-annuity.aspx
  5. Insured Retirement Institute. (n.d.). Insurance Regulation & State Guaranty Associations Questions and Answers with IRI CEO Cathy Weatherford. Retrieved from http://www.irionline.org/government-affairs/annuities-regulation-industry-information/insurance-regulation-state-guaranty-associations
  6. National Organization of Life & Health Insurance Guaranty Associations. (n.d.). Policyholder Information. Retrieved from https://www.nolhga.com/policyholderinfo/main.cfm
  7. The Motley Fool. (n.d.). Are Annuities Sheltered From Creditors? Retrieved from https://www.fool.com/knowledge-center/are-annuities-sheltered-from-creditors.aspx
  8. Haithcock, S. (2013, October 8). How annuities can shield you from creditors. Retrieved from https://www.marketwatch.com/story/how-annuities-can-shield-you-from-creditors-2013-10-08
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