Annuities: What They Are and How They Work

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

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An annuity is a financial product that basically amounts to a contract with an insurance company that agrees to provide the investor with a regular income stream, typically in retirement. Annuities require steady payments for over a year and can be purchased by the investor directly on their own or with their employer's help. 

The person who takes out the contract is referred to as the "annuitant." They can buy annuities or invest in them via a single lump-sum payment or by making monthly premium payments over a period of time. 

The firm that holds the annuity establishes a steady stream of payments to be made over a set time period. In most cases, annuities are used as guaranteed regular payments in retirement 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, because invested cash is, by its very nature, illiquid. Annuities may also be subject to withdrawal penalties.

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Rules and regulations: the Securities and Exchange Commission and the Financial Industry Regulatory Authority 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.

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 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 in order to receive steady, guaranteed income stretching into the future. Payouts may be made monthly, quarterly, semiannually or annually.

Deferred annuities: are 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: 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: also grow on a tax-deferred basis, although they also 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 other secondary kinds. An equity-indexed annuity mixes 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 they die before the payouts begin, the heirs don't get the remaining money.

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?

One advantage of an annuity is having regular, guaranteed payments that will last until the end of the annuitant's life, which reduces the risk of outliving your savings. Additionally, being able to defer taxes on contributions to the annuity can delay your tax liability until a time when you're in a lower tax bracket. Annuities can also allow for additional retirement savings if other retirement accounts are maxed out. 

On the other hand, if you pass away suddenly, you will lose the income benefit. Therefore, your heirs won't receive the money in many cases. However, you may be able to pay extra to designate a beneficiary, depending on the contract. Additionally, annuities are illiquid, meaning you might not have access to the money if you need it suddenly.

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Jacob Wolinsky

Jacob is the founder and CEO of ValueWalk. What started as a hobby 10 years ago turned into a well-known financial media empire focusing in particular on simplifying the opaque world of the hedge fund world. Before doing ValueWalk full time, Jacob worked as an equity analyst specializing in mid and small-cap stocks. Jacob also worked in business development for hedge funds. He lives with his wife and five children in New Jersey. Full Disclosure: Jacob only invests in broad-based ETFs and mutual funds to avoid any conflict of interest.