Annuities: What They Are and How They Work

Learn about the different types of annuities and their pros and cons

Annuities are having a moment. Americans looking for a conservative way to grow their money or access a regular income stream increasingly turn to annuities for retirement planning . After all, this form of investment vehicle tends to benefit from high interest rates, and we've been in a high-interest-rate economy since 2022. Even as the Red cutsa interest rates, the appetite for annuities only seems to grow.

Despite their popularity, many people do not understand what annuities are. An annuity works a lot like Social Security . You pay a certain amount (via taxes) during your working years for guaranteed income in retirement. With an annuity, however, an insurance company acts like Uncle Sam. So, you establish a contract with an insurance company, paying installments over time or a lump sum. Then, in retirement, you receive a fixed sum of money periodically over a specific period or for your lifetime from the annuity. You can purchase annuities directly on your own or with your employer's help if the annuities are offered in a tax-advantaged retirement savings account such as a 401(k).

Annuities have a very specific place in somebody’s portfolio for retirement. There are a number of different kinds of annuities that offer some sort of income protection and/or guaranteed rate of return for really conservative focused clients.

Annuity definition and terms to know

1. Annuity: It’s a contract between an insurance company and an individual in which a fixed sum of money is paid periodically over a specific period of time or for the person’s lifetime.

2. Annuization: The process of converting the investment into the periodic income payments.

3. Annuity contract: This is the legal and binding contract that spells out the terms of the annuity including the schedule of payments, surrender fees (we’ll get to that later) and costs associated with the annuity.

4. Accumulation phase: This is the period in which you make payments to the insurance company. It can be periodically or a lump sum. That money is invested with the aim of it growing over time.

5. Distribution phase: This is the period in which you begin to receive periodic payments.

6. Death benefit: If you own an annuity you must designate a person who will receive any payments due if you were to pass. That person is known as the beneficiary.

7. Fixed annuity: Payments are made monthly for the same amount. With a fixed annuity you know exactly how much you’ll receive monthly.

8. Variable annuity: The payouts are tied to the rise and fall of the underlying investment. If the investment thrives account holders have the opportunity to increase the payout. But if the underlying investment falls, so does the payout amount.

9. Indexed annuity: The payouts are tied to the performance of an index such as the S&P 500.

10. Immediate annuity: With this type of annuity you typically purchase it with a lump sum and then begin receiving payments within 12 months or less. An immediate annuity can be fixed or variable.

11. Income for life annuity: Payouts are for life no matter what age you live to. The size of the payments depend on the account size and the life expectancy of the person holding the annuity. This type of annuity can be fixed or variable.

12. Surrender charge: A penalty that’s deducted from the account value if money is withdrawn from the annuity prematurely. The surrender charge can vary based on the insurance company, the age of the annuity and amount withdrawn.

13. Free look period: This is the window in which the annuity holders can cancel the contract and receive the initial payment or the value of the annuity contract depending on the rules of the state the account holder resides in. It’s typically between ten and thirty days.

14. Rider: This is additional benefits you can add to your annuity for a fee. Common types of annuity riders include living benefits and death benefits. Living benefit riders provide additional benefits during the life of the annuity contract while death benefits allow you to pass on the benefits to someone else after the account holder dies. For married people a death rider can provide

How annuities work

The insurance company that holds the annuity establishes a steady stream of payments to the buyer over a set period. In most cases, annuities are used as guaranteed regular retirement payments and are designed to help people avoid outliving their retirement savings.

Annuities aren't recommended for people before they reach their retirement years or for those who need access to their cash. That's because invested cash is, by its very nature, illiquid — and it takes time to convert into cash quickly without incurring significant expense. Annuities may also be subject to withdrawal penalties.

There are multi-year guaranteed annuities with shorter contract terms, typically three, five and seven years. Multi-year annuities function very similarly to a bank CD in its design but are issued by insurance companies.

Three parties are involved in the annuity contract: the insurance company, which owns the annuity; the annuitant, or the person who takes out the contract; and the beneficiary, or the person who receives the payout. The annuitant pays the premiums and is responsible for any taxes once the contract ends. The annuitant is also typically the person who names the beneficiary.

When it comes to paying for the annuity, the annuitant can either make a one-time payment to fund it in its entirety or make premium payments over a period of time. With the latter payment method there are flexible premium contracts that let you pay whatever you want whenever you want within predetermined limits and scheduled premium contracts in which the amount and frequency of the payments are clearly defined.

Most annuities offer a free look period, which is the window in which annuity holders can cancel the contract and receive the initial payment or the value of the annuity contract, depending on the rules of the state the account holder resides in. It’s typically between ten and thirty days. Outside of that free look period, your money is locked up until the contract expires. “The biggest trade-off with annuities is that you surrender control of the asset to the insurance company,” says Nuss.

What are the phases of an annuity?

Annuities go through two basic phases. The first is the accumulation phase, which is the time period during which the annuity is being funded before the payouts begin. All the money that's invested in the annuity during this accumulation phase grows on a tax deferred basis .

The second phase is the annuitization phase, which is when the payouts are occurring. Most annuities also have a surrender period, during which the annuitant can't withdraw any money without paying a fee. Most insurance companies allow annuitants to withdraw up to 10% of the value of the account without having to pay a surrender fee. However, withdrawing more than that may trigger a penalty, even after the surrender period is over.

What are the main types of annuities?

Annuities can be either immediate or tax deferred, depending on when you begin to receive payments. Types of annuities include fixed, variable, and indexed.

Immediate annuities: People who receive a large sum of money all at once, such as from a settlement on a lawsuit, may choose to exchange the funds to receive steady, guaranteed income stretching into the future. Payouts may be made monthly, quarterly, semiannually or annually.

Deferred annuities: This type of annuity is designed to grow on a tax-deferred basis, providing guaranteed income to the annuitant starting on a particular date they choose. The savings period for deferred annuities can last from a few years to decades, and the money grows over time.

Fixed annuities: Fixed annuities have guaranteed interest rates that are fixed, and the money grows on a tax-deferred basis over time. Technically, fixed annuities are also deferred annuities because they don't start paying immediately. However, they are also slightly different from a deferred annuity because the annuitant can decide when the payments will begin.

Variable annuities: These also grow on a tax-deferred basis, although they offer additional choices. The amounts of the regular payouts in retirement are based on how your selected investments perform, resulting in variable payouts over time rather than fixed guaranteed payments.

Secondary annuities: Aside from the four main types of annuities, there are three secondary kinds.

• Equity-indexed annuities mix the features of variable and fixed annuities, providing a guaranteed minimum payment that could increase if the annuitant's investments outperform.
• A longevity annuity requires the annuitant to wait until around age 80 before payouts begin. At that point, the payouts are guaranteed to last until the end of the person's life. However, if the annuitant dies before the payouts begin, the heirs don't get the remaining money. This is just one strategy for managing longevity risk in retirement .
• A retirement annuity accumulates retirement funds while the annuitant is still working. Upon retirement, two-thirds of the money saved is used to buy an annuity.

What are the advantages and disadvantages of annuities?

Annuities have several advantages over some other forms of retirement savings as well as disadvantages to keep in mind.

Advantages

• Guaranteed income. An annuity can provide income, which can supplement a retiree's income from an individual retirement income (IRA) or social security.
• Regular payments. Depending on the type of annuity, annuitants can receive a lump-sum income payment or income payments on a monthly, quarterly or annual basis.
• Fixed interest rate. Annuitants can lock in an interest rate to easily budget how much income is coming in monthly, quarterly or annually.
• Tax-deferred contributions. Most annuities let buyers make tax-deferred contributions, so the money added isn’t taxed until retirement. Taxes aren’t due until the start of annuity payouts.
• No contribution limits. Unlike an IRA or 401(k), an annuity doesn’t require annual contribution limits.
• You can have more than one. There is no limit on the amount of annuities you can have. If you want a mix of annuity benefits, like one fixed contract for a guaranteed return and a variable annuity for investment upside there is nothing stopping you.
• Death benefits. Sometimes, for an additional cost, some annuities can be set up to pay a death benefit to beneficiaries, either as a lump-sum payment or a percentage of regular income payments.

Disadvantages

• Tied-up money. Most annuities let an owner take out a designated portion of their money without paying a surrender charge during the surrender period. However if there is a withdrawal before age 59½, the owner could be slapped with a tax on “ordinary” income and potentially a 10% federal income tax penalty.
• Fees and commissions. Some annuities may charge fees, such as surrender charges, mortality and expense risk fees, sales and commissions and administration fees.
• Pricey riders. In some cases, coupled with fees and commissions, a rider could further dilute your investment.
• Variable returns. If the owner has a variable annuity, the cash value goes up or down based on the performance of the market. This can lend to an uncertain income stream during retirement.

What to look for in an annuity provider?

When shopping for an annuity, investors have to consider the financial strength of the insurance company issuing the annuity. If the insurance company were to fail, you could lose your money.

While the Federal Deposit Incurance Corproation (FDIC) doesn’t cover annuities like bank deposits, they are backed by insurance guaranty associations that protect insurance policyholders and their beneficiaries if the insurance company becomes insolvent and can no longer meet its obligations. Every state, including the District of Columbia and Puerto Rico, has a state insurance guaranty association. When we are measuring the best annuities, we are looking at how long the insurance company has been in business, its balance sheet, assets versus liabilities, capital surplus and the rating from the three rating agencies AM Best, Moody’s and Standard & Poor’s.

For a multi-year guaranteed annuity, Nuss says the the baseline AM Best rating should be a B++ or higher. He says the rating should be A- or higher for annuities that are guaranteeing lifetime income.

Rules and regulations

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FIRA) regulate annuities. To be able to sell annuities, brokers must hold a life insurance license issued by their state. To sell variable annuities, they must also hold a securities license. These brokers usually earn a commission based on the contract's notional value.

Bottom line

Annuities are best suited for anyone who wants a predictable retirement income. However, because you will be giving up a substantial amount of cash in return for guaranteed income, it is best to consider each type of annuity before making a decision. It’s also best to look at any fees a provider may charge, which can dilute the value of your investment.

The first place to start is to figure out what your goals and objectives are for retirement. If any of those things involve principal protection with a guaranteed rate of return or guaranteed income, and it's something you feel you can’t achieve with your current investment lineup, then it's time to explore annuities to fill the gap.Now, as always, is the perfect time to do so to go over your options.

Note: This item first appeared in Kiplinger Personal Finance Magazine, contributed by Jacob Wolinsky, and Donna Fuscaldo, with contributions by David Rodecka, and brought to you by the RJ Fichera Law Firm, where our mission is to provide trusted, professional legal services and strategic advice to assist our clients in their personal and business matters. Our firm is committed to delivering efficient and cost-effective legal services focusing on communication, responsiveness, and attention to detail. For more information about our services, contact us today!

Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.

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