How Do Annuities Work?

Annuities Explained

Annuities are insurance products that provide a reliable, steady stream of payments to support your financial needs for the rest of your life or for a predetermined number of years. Because they are contracts, you can also customize them to meet your specific needs and fit your risk tolerance.

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, an annuity may be a fit for you.

How Do Annuities Work?

1. Annuities, an insurance product, are long-term investments that offer guaranteed monthly income payments throughout the contract’s duration.
2. The process of annuitization converts a lump-sum investment into a reliable and guaranteed future income stream.
3. The annuitant receives payments regularly, usually on a monthly basis.
4. Annuities provide financial security by ensuring a steady source of income over the contract’s lifespan.

Fixed, variable, immediate and deferred annuities dominate the market. Each also has many subtypes targeting a different set of priorities through the timing of when it will produce income and how the underlying investments grow. To illustrate, we’ve outlined four of them below: 

Read More: Types of Annuities

How Do Fixed Annuities Work?

Fixed annuities come in various forms, but all offer reliable and steady income streams tailored to individual needs. The most common example of a fixed annuity is the immediate income annuity, which guarantees monthly income payments based on the terms of the contract starting immediately. For instance, with a $100,000 fixed annuity and a 5% payout rate, you can expect to receive $5,000 annually. This example demonstrates how annuities provide financial stability and consistent income over time. 

Deferred income annuities provide the same level of fixed guaranteed payments but they contractually start the income payments at a set future date (typically 1+ years away). By deferring the income start date, the insurance company will guarantee a tax-deferred rate of return on your premium payment(s) over the period of time between your contract and income date. Most insurance companies will provide some flexibility on moving the start date, but any changes may impact the final monthly income amount.

The most basic version of the immediate or deferred income annuity will be based on a single owner’s life and the payments will end at their death. However, there are additional customizations available that can create a contract that fits the owners’ needs. For instance, it is possible to include a spouse on the contract which will make the payments last until both parties have passed away. Additionally, adding a ‘period certain’ or ‘return of principal’ rider to the contract will create a guaranteed return of money for the owners or their heirs regardless of how long they live. Adding riders like these will lower the monthly payout so it is worthwhile to compare your options before committing. 

How Do Variable Annuities Work?

Variable annuities are specialized annuities that offer the owners more control over the underlying investments of their contracts. Variable annuities, therefore, may offer higher rates of return when invested more aggressively, but they also require a higher risk tolerance because there are fewer or no guarantees. 

The most popular type of variable annuity is the variable deferred annuity, which offers the contract owner the ability to save money in a tax-deferred account. This type of contract does not have a mandatory annuitization requirement and has no limits on the amount that can be contributed over time. One of the biggest benefits of this type of annuity is to supplement the retirement investments for individuals who are already maxing out their other retirement accounts. 

Variable deferred annuities typically offer a pre-approved group of mutual funds or ETFs that the investor can invest in. Investment returns are market-based and the contract offers no guarantees on returns. Certain indexed annuities can be tied to the performance of a market index (such as the S&P 500) and may offer a floor and ceiling on monthly or yearly returns to limit both losses and gains. Like all annuity contracts, there can be specific costs and tradeoffs for these additional features. 

Variable income 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. Typically, these payout rates are evaluated on a monthly or yearly basis. This type of annuity is riskier but also has the potential to pay you more in a rising market environment. 

It is important to understand all the costs and rules associated with this type of product before buying it. In a falling market environment, your income payments will not stop, but they will be reduced. The costs associated with this type of product may degrade your ability to recover at the same rate as the market. 

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 sufficient guaranteed income in retirement, consider buying an annuity. An annuity is a good source of lifetime income.

Annuities come with many options that can be built into the contract to provide additional benefits. These riders can offer advantages such as inflation protection, a death benefit or increased protection from market risk. While these riders can enhance the value of the annuity, they often come with associated costs. To determine which riders are suitable for your annuity contract, it’s advisable to consult a knowledgeable financial professional experienced with annuities.

Chip StapletonFINRA Series 7 and Series 66 License Holder

Chip Stapleton is a financial advisor who has spent the past several years of his career working primarily in financial planning and wealth management. He is a FINRA Series 7 and Series 66 license holder and passed the CFA Level II exam in 2022.

Who Should Consider Annuities?

To give you an idea of who an annuity might be most suitable for, let’s look at a case study example.

Annuities provide a much-needed income option for consumers who want or need dependable income for a long period of time. Most types of income annuities may be considered to act like longevity insurance because they will continue to pay out income for as long as someone (and their spouse if so elected) is alive. For someone who expects to live a long life and needs a certain level of guaranteed income in excess of the amount offered through Social Security or pensions, an income annuity could be a good investment. 

A guideline to consider as you build a retirement income plan is to cover your essential expenses with guaranteed income. If your essential expenses (rent, mortgage, food, health care, etc.) exceed any social security or pension payments, consider supplementing your income via another guaranteed source like an annuity. 

Many people nearing retirement experience something called “the retirement gap,” where they have less saved for retirement than they should and risk not having enough money to continue the lifestyle they enjoyed before leaving the workforce. Annuities offer a solution to bridge the gap by providing an additional savings vehicle that grows tax deferred.

The tax deferment feature of annuities makes them ideal for high-net-worth individuals, like Ron in the example above. Ron’s annuity can earn interest while he’s still working, and he won’t be taxed for that income while he’s still in a higher tax bracket. When the contract annuitizes after Ron retires, he’ll likely be receiving less income and, therefore, could be in a lower tax bracket. As a result, he’ll end up paying less tax on his annuity earnings than he would on something like a CD, which is taxed each year as interest accumulates.

Most financial experts recommend annuities to people who are retired or about to retire and have maxed out other savings accounts such as a 401(k) or IRA. An annuity allows you to contribute as much money as you want, and you won’t be taxed on the interest your money earns until you withdraw it. In this way, a deferred annuity could be analogous to an IRA with the potential for uncapped contributions. 

Who Are Annuities Not Ideally Suited For?

While annuities can be an important part of the retirement income strategies of many consumers, they’re not for everyone. If your health in retirement is a major concern, annuities might be best 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 able to invest in stocks and other offerings that are riskier because you have time to recover losses in the long run and will benefit from avoiding the fees associated with annuity contracts. If you’re older, the safety and predictability of annuities are likely to be more suited to your needs.

The good thing about considering annuities is that many of them offer a free-look period that gives you time to consider the contract and make sure it is the right choice for your life. Each state has mandatory free-look periods and the agent offering the annuity is required to review this information with you.

Are Annuities Safe?

By and large, annuities are safe investments. However, it’s important 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. Insurance companies’ own balance sheets are solely backing the guarantees of their annuity products. 

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 NOLHGA website.

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 for annuity assets from creditors.

This is especially important for older people that depend on their savings and cannot afford to ride out a down market before or during their retirement years.

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Annuities vs. 401(k) Plans

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 2023, the annual 401(k) contribution limit is $22,550 or $30,000 if you’re 50 or older.

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 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.

Annuities are taxed one of two ways depending on how the money is withdrawn. If the contract has been annuitized, each payment will be taxable in proportion to the amount of the total contract that is growth versus principal. 

If the withdrawal is made on an unannuitized contract, the taxability of the withdrawal is handled Last-In, First-Out (LIFO). This means that the growth is withdrawn and taxed first before the nontaxable principal is withdrawn. 

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. The SECURE Act of 2019 also gives employers greater leeway to include annuities in their workplace-sponsored retirement plans.

How Much Do You Need To Start an Annuity?

Each annuity carries 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% payout rate as an example. That means, each year, you will receive payments totaling an amount equivalent to 5% 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. 

When considering an annuity as an income source, it is worthwhile to compare the expected income against the typical withdrawal rate from your invested portfolio. Most financial advisors project a safe withdrawal rate to be 4% of an invested balance. 

If an annuity can provide a greater income to you, it may be beneficial to consider it as part of your income plan. 

Read More: What If Your Annuity Provider Changes?

Frequently Asked Questions Surrounding Annuities