What are annuities and how do they work?

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Annuities are a popular approach to securing a retirement income, and millions of Americans invest in them. Annuities are designed to provide a steady stream of income during your retirement years, though they do have some notable drawbacks and can be notoriously complex.

Here’s what annuities can do for your retirement as well as what you need to watch out for.

What is an annuity?

An annuity is a contract that provides someone a stream of income, typically in retirement, in exchange for money paid into the annuity. Annuities are most often offered by insurance companies, which construct the annuity and guarantee that it’s paid as scheduled. You may purchase an annuity by depositing a lump sum or by paying into the annuity contract over time.

The annuity will pay out over whatever period is specified in the contract, perhaps that’s a fixed period such as 20 years or perhaps it’s for the remainder of the client’s life. So the annuity can offer the certainty of income and the possibility of never exhausting that income.

Types of annuities

Annuities can be broadly lumped together into three different types:

  • Fixed – A fixed annuity guarantees you a minimum rate of return on your investment and will pay out over a fixed term.
  • Variable – A variable annuity allows you to put your money into various investments, often mutual funds. What the annuity returns and pays out to you depends on how the investments perform as well as the expense ratios on any funds you invest in.
  • Indexed – An indexed annuity offers a rate of return that tracks an index such as the Standard & Poor’s 500 Index, which holds hundreds of America’s largest companies.

In addition to those three types, annuities can also be classified by when they pay out:

  • Deferred annuities pay out at some specified time in the future, perhaps at some specific age in retirement.
  • Immediate payment annuities begin paying out as soon as you deposit a lump sum.

An annuity has two broad periods in its life – the accumulation phase and the annuitization, or payout, phase. In the accumulation phase you’re putting money into the annuity, either as a lump sum or over time. In the annuitization phase, you’re taking payouts from the annuity.

Money deposited into an annuity is locked up for a period of time called the surrender period. If you decide you want out of the annuity, you’ll pay a hefty fee called a surrender charge.

Features of an annuity

Annuities can be structured in many different ways, depending on a customer’s needs. Some may guarantee that you’ll receive a certain dollar amount of payments from the account over some period. Many offer a death benefit, which may pay out on your passing, like life insurance.

One popular option is to have a longer surrender period, giving you more time to cancel. Some annuities may offer survivor’s benefits, where a spouse may continue to receive the annuity’s benefits over some period of time, and most annuities can be structured with other “riders” that offer some insurance-like benefit. Generally the more features your annuity has, the pricier it is.

So while the company issuing the contract has many different ways to create the annuity based on what you need, you’ll pay extra for all the benefits.

Tax advantages

Annuities offer tax-deferred growth on your investment until you withdraw the money. So if you pay into the annuity with after-tax money, you’ll be taxed at withdrawal only on the earnings of the account, not any principal that you take out. This feature can be valuable for those looking for a tax-advantaged way to invest.

Unlike other tax-deferred retirement accounts such as a traditional 401(k), annuities have no annual contribution maximum, allowing savers to pile away as much cash as they can. That’s a particular benefit for higher-income savers, who may otherwise want to contribute more to their retirement but have maxed out their ability to do so in a tax-advantaged way.

You can also buy an annuity inside a Roth IRA or Roth 401(k), making those payouts fully tax-free, though many experts frown on putting a complex tax-advantaged account inside another such as a Roth IRA.

The downside of annuities

An annuity can solve the challenge of finding a guaranteed stream of income in retirement, and may offer some other benefits such as a death benefit. However, it comes with quite a few downsides, and many financial advisors are suspicious of annuities for the following reasons.

1. Complexity

Annuity contracts are tremendously complex, often running to dozens of pages. In this fine print, you’ll find all the many conditions of the annuity spelled out, such as when you can get paid, how much it will cost you to cancel the contract, how much you’re guaranteed to be paid, what rate of return the annuity is based on, and all the other details that govern the agreement.

On top of this complexity, annuity contracts may differ markedly from one to the next. Annuities have some broad similarities, but the details are where annuities really stand apart. The benefits of each annuity contract may differ – allowing insurance companies to offer a specific kind of coverage that you’re looking for as well as hide some of the less flattering details of the contract.

It ought to go without saying, you’ll need to read the contract very closely to see just what your rights and responsibilities are. But even spending hours on the contract may not be enough.

2. Huge sales commissions

One of the biggest drawbacks of an annuity is the large sales commission bundled in with the product. While the commission may not be paid directly by you, it still reduces the returns that you otherwise could have earned.

Unfortunately, it’s not unusual to spot a commission at 6 or 7 percent, though they may go up to 10 percent. If you put $100,000 into an annuity, a salesperson may take $6,000 or more, though the industry may obscure how you’re charged.

In general, complex annuities with more features have higher commissions than simple annuities. An annuity with a long surrender charge period means higher commissions, too.

With that kind of incentive, it’s little wonder that insurance agents are eager to sign up clients in a complex product. It’s also a reason why you need an independent fee-only financial advisor who’s looking out for your interest, not their own personal financial interest.

3. Can be hard to cancel

Amid all the complexity of the contract, you may find how to cancel your annuity, a process that may come with substantial fees – called surrender charges – or other lost income. While there may be ways for you to wiggle out of the contract, don’t expect them to be easy or pain-free.

4. Illiquid money

Once you put your money into an annuity, it’s generally tied up for a long period of time. You’ll receive your stream of income and you may be able to withdraw some of the principal, but for the most part your money is locked into the annuity and you have relatively little access to it.

That can be problematic if you need money for an emergency and your income or other savings doesn’t suffice.

5. Variable annuities are risky

Because they may rely fully on the markets for any gain, variable annuities can potentially be quite risky, leaving you with few gains and maybe even losses after years of saving. You’ll want to invest any money for the long term so that you can ride through the dips in the market, and avoid fees that may come with an early redemption of the annuity, if you decide to go that way.

Variable annuities can also be full of fees – a mortality and expense risk charge, the expense ratios of any funds you invest in, administrative fees and any additional fees for special features that you’ve added to the account (for example, a death benefit or guaranteed minimum payout.)

And if you withdraw your money early, before age 59 1/2, you can get hit with a 10 percent bonus penalty in addition to taxes you’ll owe on any investment gains, much like the penalties for early withdrawal on traditional IRA and 401(k) accounts.

Alternatives to annuities

So many kinds of annuities exist because consumers have varying needs. But a good financial advisor can recreate many of an annuity’s benefits without as many of the drawbacks.

For example, while an annuity may promise you a 4 percent return on your money, an advisor may be able to construct a portfolio that earns you 5 percent today and offers a growing stream of dividends in future years. Such a portfolio may also offer you flexibility, too.

On the other hand, many retirees like the security of a monthly income, and an advisor can set up your portfolio to pay you cash on a regular basis just like an annuity. You may even be able to set up a life insurance contract that mimics the death benefit that is typical of many annuities.

Perhaps best of all, you can get these benefits without the same cost that you’d pay in sales commissions and still retain a much more flexible portfolio. An advisor who looks out for your best interest can find low-cost mutual funds that generate strong returns over time.

Bottom line

Annuities can solve a specific kind of problem for a specific kind of person – steady retirement income for people with little experience in financial matters – but they’re not the cure-all that they’re often pitched as. A good financial advisor can construct a plan that avoids many of the downsides of an annuity while offering many of the upsides, including a potentially higher return.

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.