An annuity is a way to get guaranteed income in retirement, but they can be complex and confusing. While they may help with retirement planning, annuities are notoriously opaque.
Thanks to the SECURE Act of 2019, sponsors of 401(k) plans can offer annuities to participating employees. Nonetheless some plan sponsors are reluctant to roll them out. A big reason: a lack of annuity fluency.
A recent survey of plan sponsors by TIAA found that adding annuities to 401(k) and other defined contribution plans may be slow to take off because of a lack of understanding about how annuities work.
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Of the plan sponsors offering annuities, only 37% said they could articulate the value and importance of annuities. Meanwhile, among plan sponsors that aren’t adding annuities to their lineup, 43% said a lack of understanding is the primary barrier to adoption.
It's not just the plan sponsors who are confused. According to the Policygenius Annuities Literacy Survey, four out of five American adults still can’t define an annuity.
If a lack of annuity fluency is keeping you from adding guaranteed income to your 401(k), we’ve got you covered.
Here’s a list of the key annuity terminology you need to know to demystify this type of retirement savings vehicle.
Annuity definition and terms to know
1. Annuity: It’s a contract between an insurance company and an individual in which a fixed sum of money is paid periodically over a specific period of time or for the person’s lifetime.
2. Annuization: The process of converting the investment into the periodic income payments.
3. Annuity contract: This is the legal and binding contract that spells out the terms of the annuity including the schedule of payments, surrender fees (we’ll get to that later) and costs associated with the annuity.
4. Annual contract fee: This is a fee paid yearly to the insurance company for administering the contract. If your annuity has a high account value it may be waived.
5. Cash value: This is the total accumulated value of the annuity. It includes the premiums you paid plus interest before withdrawals and charges.
6. Accumulation phase: This is the period in which you make payments to the insurance company. It can be periodically or a lump sum. That money is invested with the aim of it growing over time.
7. Distribution phase: This is the period in which you begin to receive periodic payments.
8. Death benefit: If you own an annuity you must designate a person who will receive any payments due if you were to pass. That person is known as the beneficiary.
9. Fixed annuity: Payments are made monthly for the same amount. With a fixed annuity you know exactly how much you’ll receive monthly.
10. Guaranteed interest rate: This applies to a fixed rate annuity and is the minimum interest the insurance company pays each year.
11. Variable annuity: The payouts are tied to the rise and fall of the underlying investment. If the investment thrives account holders have the opportunity to increase the payout. But if the underlying investment falls, so does the payout amount.
12. Indexed annuity: The payouts are tied to the performance of an index such as the S&P 500.
13. Immediate annuity: With this type of annuity you typically purchase it with a lump sum and then begin receiving payments within 12 months or less. An immediate annuity can be fixed or variable.
14. Income for life annuity: Payouts are for life no matter what age you live to. The size of the payments depend on the account size and the life expectancy of the person holding the annuity. This type of annuity can be fixed or variable.
15. Surrender charge: A penalty that’s deducted from the account value if money is withdrawn from the annuity prematurely. The surrender charge can vary based on the insurance company, the age of the annuity and amount withdrawn.
16. Free look period: This is the window in which the annuity holders can cancel the contract and receive the initial payment or the value of the annuity contract depending on the rules of the state the account holder resides in. It’s typically between ten and thirty days.
17. Rider: This is additional benefits you can add to your annuity for a fee. Common types of annuity riders include living benefits and death benefits.
Living benefit riders provide additional benefits during the life of the annuity contract while death benefits allow you to pass on the benefits to someone else after the account holder dies. For married people a death rider can provide income to the surviving spouse.
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