How Do Annuities Work: A Beginner’s Guide

Key Takeaways


One of the biggest mistakes young entrepreneurs make is failing to plan for retirement, after all when you are in your 20’s retirement can feel extremely far away. The fact of the matter is: it is never too early (or too late) to start planning for your retirement. Annuities are one popular option to help guarantee you receive income later in life. But, how do annuities work?

This investment vehicle can seem a little confusing at first, but it is much easier to understand than you might think. The following guide will better illustrate what annuities are and how they can help you prepare for your financial future. Keep reading to learn more.

What Are Annuities?

Annuities are contracts made with an insurance company, largely as a way to plan for retirement. You can buy an annuity by making a one-time purchase or by contributing money to the insurance company over time. Depending on the type of annuity, your money would then be used for other investments (like mutual funds). This is known as the accumulation phase of an annuity. In the future, you would receive your money back in a lump-sum payment or a continuous stream of income based on your initial payment and any investment gains made. This is referred to as the payout phase of an annuity.

There are several types of annuities to choose from, each with different benefits and risks. Generally speaking, they are a long-term investment strategy used to guarantee income later in life. Annuities are often used by individuals who do not have a pension or other way to secure income in retirement. They can be a relatively safe way to invest, while also promising steady returns. Additionally, they are regulated federally by the Securities and Exchange Commission (SEC) or on a state level by insurance commissions.


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what is an annuity

Types Of Annuities

There are three main types of annuities, each with slightly different investment structures. It is always a good idea to learn about the benefits offered by each type before choosing how to invest your funds. Read through the following overview of fixed, variable, and indexed annuities to learn more.

Fixed Annuities

Fixed annuities are regulated by state insurance commissions, and have a relatively straightforward structure. Essentially, a buyer makes periodic payments to the insurance company. The payments are made with a predetermined interest rate on the funds. Once the payout phase begins, buyers receive their funds along with the additional interest. Two fixed annuity examples depend on the payout structure:

  • Immediate Fixed-Income Annuities: Immediate fixed-income annuities are perfect for individuals approaching retirement. This structure allows you to make a lump-sum payment for an annuity, with the guarantee to receive income over time. The payout phase of the annuity begins immediately and continues for as long as the contract states.

  • Deferred Income Annuities: A deferred income annuity is exactly what it sounds like: the payout is deferred until a set point in time. The payout period will be specified in the contract and can be months or years away, depending on when you need the income to start. During this time (the accumulation period) your payments would continue to grow through interest.

Variable Annuities

Variable annuities can require a more thorough understanding of investing when compared to other annuity types. With a variable annuity, buyers get to decide where they want their payments invested. Typically variable annuities go into mutual funds. The future payout would then depend on the performance of their investment choice, minus any management fees associated with the account. This structure can provide the opportunity for a higher payout, but could just as easily result in a disappointing payout depending on the mutual fund. Variable annuities are regulated by the SEC as a way to help protect investors from fraud.

Indexed Annuities

Indexed annuities are perfect for those who prefer the freedom of variable annuities, but also want the security of a fixed-income annuity. They pay interest based on the performance of a market index, usually the S&P 500. Indexed annuities can offer higher returns in retirement if the market performs well, though the gains are not usually as high as variable annuities. The reason for this is because indexed annuities attempt to offer protection against market downturns by offering minimum guaranteed rates, typically between 1 and 3 percent. Indexed annuities are regulated by state insurance commissions.

Variable Annuity Fees

Variable annuities can be a great way to grow your money for retirement, but there are certain fees to be aware of. You must consider these costs in relation to the potential returns, so the future payout does not catch you off guard. The following are just some of the fees you may see associated with a variable annuity:

  • Administrative Fees: The insurance company you work with may charge a base fee for any administrative duties associated with your account, such as record keeping. Administrative fees can either be one annual fee or a percentage of your account value.

  • Mortality And Expense Risk Charge: While the name sounds confusing, this is essentially a percentage of your account used to pay the company that sold you the annuity. The purpose of a mortality and expense risk charge is to cover the risk assumed by the insurance company when issuing an annuity.

  • Fund Expenses There are baseline fees associated with maintaining your annuity account. Fund expenses typically pay for the cost of making the underlying mutual fund investment.

  • Additional Fees: If there are any underlying features to your annuity contract, such as a minimum income guarantee, there are often charges applied to cover those costs. These are referred to as general fund expenses and will vary based on your account.

How To Buy & Sell Annuities

Annuities can be purchased from most insurance companies, brokerage firms, mutual fund companies, and even some banks. These organizations will issue an annuity contract, specifying the terms of payments as well as any associated fees. If you are interested in a variable annuity, you will also receive information about the available mutual funds at this time. Be sure to request as much information as you need to make a decision, as this will help you understand where to allocate your funds.

If you opt to sell your annuity or withdraw money before the payout period there are penalties to be aware of. These are often called “surrender charges” and will vary based on where you purchased the annuity. The surrender charges will take away from the total value of your investment, potentially undermining any gains that were made. Always be aware of the risks associated with selling an annuity before starting your investment.

Annuities vs. A 401(k)

A 401(k) is another popular investment option when planning for retirement. Much like an annuity, these accounts can provide individuals with some control over how their money is invested for the future. However, there are some key differences between 401(k) accounts and annuities for retirement:

  • Contribution Limits There is a maximum amount you can put into your 401(k) each year, typically around $20,000. There is no limit on purchasing annuities.

  • Tax Deductions: The contributions made to your 401(k) can be deducted from your taxes each year, while annuity contributions cannot.

  • Availability: Annuities can be purchased by anyone, but it is only possible to open a 401(k) account through your employer.

  • Withdrawals: Funds withdrawn from a 401(k) will be taxed as income, based on which tax bracket you are in. Annuity payments are only taxed based on the investment gains.

annuity definition

Pros & Cons Of Annuities

There are several pros and cons to consider before deciding whether or not to purchase annuities. While they can be a great way to bolster your retirement funds, there are certain risks associated. Familiarize yourself with the advantages and disadvantages of annuities below.

Advantages Of Annuities

The biggest advantage of annuities is the guaranteed retirement income they can provide. Whether you choose to receive a lump sum or regular payments, annuities are one way to ensure income later in life. This can allow you to live comfortably in retirement, and provide peace of mind about the future. Annuities can be especially helpful to anyone without a pension or other employment-based retirement account.

Annuities are also thought to be a largely “safe” investment — meaning they are not usually the subject of fraud or other investment scandals. The reason for this is because annuities are highly regulated, either by the SEC or your state’s insurance commission. This can make all the difference for individuals worried about properly managing their retirement funds.
Finally, some annuity accounts will offer a guaranteed minimum payment. This protection is crucial for individuals who cannot afford to wait out a market downturn. If you are approaching retirement age and want to purchase an annuity, always double-check the offered minimum payments to ensure you are protected.

Disadvantages Of Annuities

The biggest drawback of annuities is commonly acknowledged as the fees associated with annuity management. Insurance companies can charge fees based on the overall performance of your account, essentially cutting into any profits you make. It is important to keep these fees in mind before purchasing an annuity so you are not met with any surprises once you reach the payout phase in retirement. Always make sure you are aware of the various costs associated with an annuity before you buy the contract.

Annuities are not for everyone, especially those without a strong emergency fund. Once you purchase an annuity, you typically cannot get your money back until the payout period begins. There are steep penalties for withdrawing funds from an annuity, which in some cases can even cut into your initial investment. The best way to prepare for this is to always make sure you have savings in case an unexpected financial emergency were to occur.

Are Annuities A Good Investment?

Annuities can be a good investment for individuals looking to secure a stream of income after retirement. If you find yourself in a career without a pension or 401(k), annuities are one option to consider. While they may not always be a good fit for your specific needs, they are one of several ways to plan for your financial future. Annuities are also thought to be a relatively safe way to prepare for retirement, especially when purchasing from reputable insurance or financial companies.

Summary

There are so many investment options available to help you plan for retirement: self-directed IRAs, 401(k)s, and even annuities. Each investment type will come with its own pros and cons, but they all aim to help you live comfortably later in life. The most important thing to remember is that you can start planning for your retirement, no matter what age you are. Asking “how do annuities work” is only the first step in preparing for your financial future.

Do you have any other questions about annuities? We can help answer them in the comments below.

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