What Is an Annuity?

Annuities are popular financial products for retirement because they offer tax-deferred growth and a guaranteed income stream.

You can purchase an annuity in a single payment, called a lump-sum premium, or with multiple payments.

Annuities work by offering flexibility and hedging against longevity risk — the threat of running out of money in retirement.

Payout options for annuities include a lump sum, a series of payments distributed over a specific time period or guaranteed payments for life.

Annuities and life insurance share similarities. Both offer protection against risk and take the form of a written contract between you and an insurance company.

However, these products serve very different purposes.

Life insurance is protection in case you die too soon. An annuity is protection against outliving your money.

In other words, life insurance protects your beneficiaries if you pass away prematurely while an annuity protects your income if you live longer than expected. Both are common components of retirement planning.

Annuities come in all shapes and sizes. The right type of annuity for you depends on many factors, including your income, risk tolerance and when you want to begin receiving payments.

A fixed annuity guarantees a return of your premium plus a minimum interest rate. The interest rate may be guaranteed or may fluctuate from year to year, depending on your contract.

Fixed annuities are considered predictable ways to ensure income after exiting the workforce. Payouts are not affected by fluctuations in the market, so they can provide peace of mind for those nearing retirement.

According to the U.S. Securities and Exchange Commission, interest rates for indexed annuities are tied to an equity index, such as the Nasdaq. Indexed annuities carry more risk than fixed annuities, but less risk than variable annuities.

With a variable annuity, the money you pay is allocated to an investment portfolio. These underlying investments, or subaccounts, may include stocks, mutual funds, bonds, money market funds or other options.

The amount of money you receive will vary depending on how much money you put in and the performance of your underlying investments.

You may be able to purchase a rider for an extra fee that offers a guaranteed minimum withdrawal or income benefit, even when market performance is poor.

Qualified longevity annuity contracts (QLACs) are financial products that provide regular income payments to individuals starting at a specified age, typically age 80 or 85. These annuities are designed to help retirees avoid outliving their savings by transferring the risk of longevity to an insurance company.

QLACs are unique from other types of annuities in that they can be purchased with funds from a qualified retirement account such as a 401(k) or IRA and are exempt from required minimum distribution rules until age 85.

Annuities are sold by insurance companies as well as some banks, brokerage firms and mutual fund companies.

One of the greatest benefits of an annuity is a guaranteed income stream that gives people peace of mind by ensuring their needs will be met during retirement.

Annuities provide what the industry calls “longevity insurance,” or protection against outliving your savings.

Pensions are increasingly rare in the United States and Social Security may not cover all your living expenses. A retirement savings account, such as a 401(k), can help bridge this gap, but these plans don’t offer the same income guarantee as annuities.

Annuities are also beneficial for retirees because they offer a death benefit to loved ones. If you die before you start receiving annuity payments, your designated beneficiary will receive payment instead.