How Do Annuities Work?

An annuity, in the strictest sense, is a contract between you and an insurance company. This agreement states that you will give the insurance company a certain amount of money, and in exchange it will pay you a predictable and guaranteed amount for a specified length of time.

An annuity is a series of payments designed mainly for retirement income. One of the most common and well-known types of annuities is a pension.

Annuities are one of many financial products designed for retirement saving and investing. Like any tool, they serve a specific purpose. Most annuities are intended to provide stable, guaranteed rates of return or income before and during retirement.

There are many types of annuities, each with its own benefits and drawbacks. When considering purchasing an annuity, it’s essential to know the following information.

Annuities come in various forms, each designed with specific purposes, advantages and disadvantages. Just as you wouldn’t use a screwdriver in place of a wrench, you shouldn’t use annuities interchangeably.

These products generally fall into two main categories—income annuities and accumulation annuities—depending on their primary purpose for the owner.

Income annuities pay out a guaranteed income stream now or in the future.

An immediate income annuity starts providing income within 1 to 12 months from the purchase date. For instance, a Single Premium Immediate Annuity (SPIA) is funded with a lump sum and delivers lifetime income within a year.

On the other hand, a deferred income annuity (DIA) begins paying income more than 12 months after purchase, or may not have a specific start date. It offers guaranteed growth on contributions until the scheduled income date, at which point it converts to an immediate income annuity and starts paying out a steady stream of income.

Accumulation annuities grow the owner’s assets over time and may or may not be turned into income in the future. Annuities come with different types of returns, which can be broadly categorized into fixed and variable returns.

Fixed return contracts offer a predetermined and guaranteed rate of return for a specific term, after which the rate may no longer be guaranteed. While Certificates of Deposit (CDs) are not annuities, they provide a similar fixed rate of return for a set period before maturing. A Multi-Year Guaranteed Annuity (MYGA) operates in a similar manner, ensuring a guaranteed return over a specified term.

In contrast, variable returns allow returns to fluctuate based on market performance. These annuities typically invest in mutual funds or are linked to market indices such as the S&P 500 or the Barclays Aggregate Bond Index. A common example is the variable annuity, which offers tax-deferred market exposure and often includes options to add guarantees related to future income, withdrawals or death benefits through optional riders.

As annuities have evolved, financial companies have introduced products that blend guaranteed returns with market-based returns. These innovative products provide investors with the opportunity to benefit from market growth while maintaining some level of downside protection, offering a balanced approach to growth potential and risk management.

Insurance companies, like those offering financial advice, mutual funds or brokerage services, sell products for profit. They primarily earn money on annuities through investment earnings and annual fees.

Most annuities generate income for insurers by paying out less to policyholders than what the insurers earn from investing the principal payments. By securing a higher rate of return on these investments than the payouts made, insurers can cover their guarantees, business expenses and liabilities while aiming to book a profit.

For example, an insurer offering an immediate income annuity with a 6.0% payout rate for guaranteed lifetime income expects to earn more from investments than it will pay out over the policy’s duration. By applying the Law of Large Numbers, the insurer can estimate with relative certainty the lifespan of policyholders and compare total payouts to expected investment earnings. By distributing this risk across thousands of policies, the insurance company can offer attractive guarantees to policyholders seeking reliable income payments.

Some annuity contracts, particularly those with variable or market-based returns, have annual or product fees. These fees may include a flat annual percentage fee for owning the annuity or additional percentage fees for optional contract riders.

The application of these fees varies by contract, so annuity customers should review and evaluate them carefully before purchase. An annual fee does not automatically mean the product lacks value. As with any investment product, fees are important and you should compare similar products to achieve the best results and security for your money. However, keep in mind that certain guarantees often require compensating the insurer for the associated risks.

Annuities can be good investments when circumstances are right. Whether someone should buy one depends on various factors, as everyone’s financial situations, needs and priorities are different.

Like many financial decisions, building a retirement plan can be complicated. Annuities are a useful tool, but one type may be perfect for one person while another might need a different type. For example, a couple with no children who are uncomfortable managing their investments might find a joint income annuity that provides a guaranteed monthly income for life ideal for a carefree retirement. Income annuities can be excellent for creating enough guaranteed income to cover all essential expenses.

On the other hand, a pre-retiree in a high tax bracket who is a few years from retirement and concerned about economic fluctuations might benefit from a MYGA. This option offers a guaranteed rate of return and tax deferral, helping to minimize taxes until retirement.

However, if you have a pension and Social Security that cover most of your annual expenses, you likely won’t need an annuity. In this case, you essentially already have a form of guaranteed income through your pension, and additional guarantees may not be necessary.

Annuities offer a range of benefits, such as guaranteed income and tax-deferred growth, making them a valuable tool in retirement planning. However, they also come with potential drawbacks, including fees and limited liquidity. Understanding both the advantages and disadvantages of annuities is key for determining if they align with your financial goals and needs.

Annuities sold in every state include a Free Look Period, which typically ranges from 10 to 30 days (varying by state). This period allows you to review and potentially cancel the policy without incurring any costs or penalties. It provides additional time to reflect on the policy and ensure it is the right decision for you.

Annuities are investment products as well as income sources. Unlike other investments such as stocks, bonds or mutual funds, they allow you to transfer the risk of outliving your retirement savings to an insurance company that will guarantee your rate of return or your stream of income.

Annuities can help diversify your portfolio or support your investment goals by minimizing the income demand on your invested assets. Their stability and relatively safe nature can help balance higher-risk investments that fluctuate with the stock market.

Retirement accounts and retirement-focused investment options, such as annuities, should be viewed as tools to help achieve the ultimate goal of building a solid retirement plan. Each account has its own strengths and weaknesses, and many investors will find that different options become more relevant as they approach retirement.

Annuities, in particular, stand out by offering safe, predictable returns and guaranteed lifetime income. For soon-to-be retirees looking to step into retirement with confidence, these benefits can be more appealing than the higher risk and potential rewards of stock market investments.

Editor Norah Layne contributed to this article.