How Do Annuities Work?

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.

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.

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.

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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.

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.

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.

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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.

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.

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.

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.

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

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

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.

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.

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