Last Updated: July 2020
From the broadest perspective, an annuity works like a lot of other financial planning tools: You give up money now in exchange for more financial stability in the future.
But annuities also have some significant differences — both strengths and weaknesses — when compared to other financial planning products.
Exploring these differences can help determine whether annuities should be part of your financial plan or if they’d be a bad idea.
First Things First: What Is an Annuity?
Annuities confuse a lot of people, including some financial advisors, because they’re not actually investments in the technical sense of the term. Instead, an annuity is an insurance contract.
On the surface, they’re simple enough: An annuity works very much like a pension.
You deposit a sum of money now in exchange for regular payments later in life, presumably after you’ve retired and no longer earn income.
So why would you exchange a lump sum of money now for the promise of payments in the future?
Couldn’t you simply put the money in an investment, a savings account, or an individual retirement account (IRA) until you retire?
Those questions get at the heart of why annuities exist: With an annuity, you could continue to receive payments even after you’ve reclaimed all the money you spent on the annuity’s premium.
This is possible because an annuity isn’t an investment or an account you can deplete. It’s an agreement.
Annuities seem more confusing when we try to treat them like investments.
The Different Types of Annuities
- How soon will you start receiving annuity payments?
- How will the annuity invest your money?
- How much will you pay in fees?
- How big will your payments be?
Answering these questions will help you decide whether you should buy into an annuity contract. The answers will depend, in part, on the type of annuity you buy.
A fixed income annuity offers the most basic approach. You provide the sum of money, known as the premium, and the insurance company agrees to make payments to you beginning either soon (immediate annuity), or in the future (deferred income annuity).
Once payments begin, you can receive them annually, quarterly, or monthly. Or, you can set up your annuity to make a lump sum payment back to you in the future.
You can also decide whether to receive payments for a set period of time, known as a term, or for the rest of your life. Term annuity payouts tend to be higher than lifetime payouts.
Decisions like how soon and for how long you’ll receive payments help determine your annuity rate. Your annuity rate impacts the size of your regular payments. We’ll get more into annuity rates below.
As its name indicates, an immediate annuity starts providing income for you right away — as soon as a month from now in many cases. Some firms call immediate annuities “income annuities.”
Immediate, fixed annuities provide a contract: You exchange your sum of money for the promise of regular payments. These products work a lot like a life insurance policy.
We’ll get into the more complex scenarios now.
Deferred Income Annuity
Once again, the name gives it away: With a deferred income annuity, your payments begin sometime after you’ve funded the annuity contract.
These annuities work a lot like IRAs. The money in your annuity can gain interest before you start receiving payments, and it can continue to grow even after payouts begin.
Deferred income annuities can also offer tax advantages like IRAs but with no limit on deposits. You can fund a deferred income annuity in two ways:
- As a lump-sum premium just like an immediate annuity.
- As a series of deposits over an extended period of time as you would with an IRA.
As for payouts, you can set them up on a term or for the rest of your life.
A variable annuity is a specific kind of deferred income annuity. Rather than growing at an interest rate like a savings account, the insurance company will invest your premium in mutual funds.
Depending on how the markets perform, your principal could grow, resulting in higher payments for you in the future.
Your principal could also decline, which is one of the biggest drawbacks of a variable annuity.
For example, if you funded an annuity contract right before the stock market entered an extended period of decline, your annuity could steadily decline in value, resulting in lower payments.
Other negatives include:
- Delays in payments: Many insurance companies require a waiting period before you can start receiving payments. Conditions vary, but some waiting periods can be 10 years or longer.
- Lack of transparency: Since insurance companies invest your premium in mutual funds and not in publicly traded funds, you won’t be able to get easy updates about your funds’ performance.
- Higher fees: We’ll get into this below, but ongoing fees for variable annuities make these products cost-prohibitive.
Fixed Indexed Annuity
If you’re looking for balance, check out a fixed indexed annuity. With these annuities, you can participate in the market without being fully exposed to potential for loss.
Your annuity’s premium will be tied to a stock index like the S&P 500, allowing for principal growth like with a variable annuity.
But unlike a variable annuity, the insurance company can guarantee your principal and your annual payouts won’t fall below a certain level, protecting you against the potential for decline.
In exchange for this protection, the company will also cap your growth potential. If your annuity is capped at 5 percent and the market grows 20 percent, you’ll still benefit from only 5 percent.
Determining an Annuity’s Payout
How much income could an annuity provide during retirement? The answer depends in part on your annuity rate.
Unlike with savings accounts or CDs, your annuity rate isn’t an interest rate. The amount your principal earns isn’t determined directly by economic conditions.
Instead, your payout is determined by the annuity contract agreement you enter into with the insurance company. The details of the contract will determine your payout rate.
What Affects an Annuity’s Rate
As we’ve already discussed, annuities are life insurance products. Life insurance lets you leverage a large, future payout in exchange for paying smaller, regular premiums in the meantime.
An annuity reverses this familiar arrangement: You pay a larger premium upfront in exchange for smaller, regular payouts in the future.
Just like with a life insurance policy, the risk your annuity presents can impact your annuity rate:
- Life Expectancy: The longer your life expectancy, the lower your annuity rate. For example, women, who live longer on average, will have a lower annuity payout rate than men.
- Age: The older you are when you start receiving annuity payments, the higher your rate should be. Why? Because you have fewer months, on average, to spread your payouts across.
- Annuity Type: A variable annuity can pay out a higher (or lower) rate than a comparable fixed annuity depending on the market’s performance during the contract period.
- Economic Conditions: Even though an annuity is a contract and not an investment, the insurance company does invest your principal. So economic conditions such as interest rates when you enter the contract will affect payouts. Generally speaking, if interest rates are lower you’ll get a lower annuity rate.
- Riders: Just like with life insurance, you can add special conditions to your annuity to add flexibility. Generally, the more riders you have, the lower your payout rate.
Determining an Annuity’s Cost
An annuity can easily become cost-prohibitive. Before buying one, be sure you understand exactly how much you’ll be paying, both in built-in costs, hidden costs, and in tax liability now or in the future.
Let’s break down some of these costs by categorizing them:
When you buy an annuity, you could be paying fees you don’t know about because they’re built into the structure of the annuity.
- Commissions: The insurance agent or broker who sells you the annuity could be claiming up to 10 percent in sales commissions. Commissions average 5 to 6 percent. A 5 percent commission on a $100,000 annuity would be $5,000. You might not notice this cost; it will simply cut into your future payout rate.
- Ongoing fees: Variable annuities will charge annual fees for investing your premium. These fees can reach an additional 3 percent a year. For a $100,000 annuity, that’s $3,000 every year. Unless your variable annuity gains more than 3 percent in value, you’d be losing money. Again, these fees are built-in and not immediately obvious.
- Surrender fees: If your financial situation changes and you’d like to access the principal of your deferred income annuity, you may be charged an early withdrawal penalty, known as a surrender fee. Many annuities let you withdraw up to 10 percent penalty-free. Surrender fees can decrease the longer you own the annuity.
To avoid overpaying, ask a trusted financial professional on how to find the lowest commissions and rates. Buying an annuity directly from a captive insurance agent tends to cost more.
Economists might refer to these hidden costs as opportunity costs: By investing a lump sum in an annuity, you’re losing the opportunity to invest the same money elsewhere.
This becomes an issue especially with fixed indexed annuities that have caps on earnings.
Let’s say you funded a $100,000 annuity contract with a 5 percent cap on annual growth. If you could have earned 10 percent on that money elsewhere, your hidden cost would be 5 percent, or $5,000.
What do you get in return for this hidden cost? You no longer have to worry about managing the investment yourself, and you can get a guaranteed minimum payout later in life no matter what happens with the premium.
Keep in mind, though, variable annuities do not offer this minimum return guarantee. If your premium loses value in the market, your payout will be lower.
Only a tax professional — not an insurance agent or a broker who sells annuities — should advise you on the tax implications of an annuity.
How you’re taxed on money you contribute or withdraw from an annuity depends in part on whether the money you contributed has already been taxed.
If you use money from a traditional IRA to buy an annuity, for example, you’d be using untaxed money.
However, deferred income annuities offer tax advantages such as no caps on how much you can contribute. This is why lottery winners or people who score big at the roulette table often develop a keen interest in annuities.
Cost of Extra Features
Just like with a life insurance policy, you could name a beneficiary for your annuity in case you die before enjoying the benefits.
You can also buy and maintain an annuity but direct the payments to someone else known as an annuitant.
Added flexibilities like these must be specified in the annuity contract, and they can add significantly to the amount you’ll pay.
What Sets an Annuity Apart?
An annuity’s fees can get out of control quickly. A variable annuity, in particular, is so risky many financial planners advise their clients to simply stay away from them.
Still, thousands of people each year buy annuities, including variable annuities. Couldn’t the same people put their money in a high-yield savings account or a series of CDs?
Or, in the case of a variable annuity, couldn’t you just invest your money in mutual funds or exchange-traded funds without going through an annuity contract?
The answer, of course, is yes, which means annuities must have other appeals. One appeal comes from your ability to stop managing your own money. With an annuity, you’re paying an insurance company to worry about the details.
Making Sure You Have Income
The main appeal of an annuity is its “guarantee” of an income stream later in life. This guarantee is possible only because an annuity is an insurance contract and not an investment in the technical sense of the term.
If you lived to be 105, for example, your lifelong annuity could still send periodic payments according to the terms of your annuity contract, even after you’d exhausted the premium you’d paid decades earlier.
In this sense, an annuity insures you against running out of money.
Of course, this insurance is only as good as the company issuing it. Unlike your savings account, funds you invest in an annuity are not FDIC insured. If the insurance company folds, you could lose your principal and your future annual payments.
As you consider annuities, make sure you have a discussion with a financial planner and be sure you’re working with a highly rated insurance company. Check A.M. Best, Moody’s, or other independent ratings agencies for your insurance company’s grade.
If you’re not confident in your decisions, take some time to figure it out.