What are annuities and how do they work?

Annuities allow individuals to pay upfront or over time to receive a consistent income stream. Because they can provide predictable income, annuities are a popular approach to securing retirement income. This is especially true as pensions have become less common in the private sector. Like most financial products, however, annuities have their share of benefits and drawbacks, such as high fees and complex contracts. 

Here’s how annuities work and what to consider before purchasing an annuity. 

What is an annuity?

An annuity is a contract with an insurance company that provides a stream of income, typically in retirement, in exchange for money paid into the annuity. People often invest in annuities as part of their broader retirement strategy, including life insurance or traditional retirement accounts, such as an IRA.

Sold as an insurance product, annuities are constructed to pay out on a predictable schedule. You may purchase an annuity by depositing a lump sum or by funding the contract over time with a series of premium payments.

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

Individuals can broadly lump annuities 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 and 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 S&P 500, 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 annuities begin paying out within a year or less of purchase.

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 as a lump sum or payments over time. In the annuitization stage, you’re taking payouts from the annuity.

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

In the table below, you can see how the three main types of annuities compare based on critical benefits:

Features of an annuity

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

One popular option is 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 time, and most annuities can be structured with other “riders” that offer some insurance-like benefit. Generally, the more riders your annuity has, the pricier it is.

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

Tax advantages of an annuity

Qualified annuities offer tax-deferred growth on your investment until you withdraw the money or begin receiving payments. This feature can be valuable for those looking for a tax-advantaged way to save for retirement. If you fund a nonqualified annuity with after-tax money, you’ll be taxed at withdrawal only on the earnings, not any principal that you take out. 

Like other tax-deferred retirement accounts, such as a traditional 401(k), qualified annuities have annual contribution limits but nonqualified annuities — like brokerage accounts — have no limits. That’s a particular benefit for higher-income savers, who may otherwise want to contribute more to their retirement but have maxed out a 401(k) or IRA.

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

The downside of annuities

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

Complexity

Annuity contracts are tremendously complex, often totalling 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, the guaranteed payment, 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 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 and hide some of the less flattering details of the contract.

You’ll need to read the contract closely to understand your rights and responsibilities. But even spending hours on the contract may not be enough to fully grasp the conditions contained within. It may be wisest to seek help from a financial advisor.

High sales commissions

One of the most significant drawbacks of an annuity is the large sales commission baked into the product. While you may not pay the commission directly, it still reduces the returns 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 insurance company may obscure how you’re charged.

Complex annuities with more features generally have higher commissions than simple annuities. An annuity with an extended surrender charge period may mean 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 may want to consider getting a second opinion from an independent fee-only financial advisor who’s looking out for your interest.

Difficult to cancel

Amid all the complexity of the contract, you may find how to get out of your annuity, a process that usually carries substantial fees called surrender charges. Surrender charges typically last six to eight years after signing the annuity contract, and tend to decrease over time. While there may be ways for you to wiggle out of the contract, don’t expect them to be easy or free.

You can also choose to sell your annuity payments. There are several reasons you may choose to sell the payments, like an unexpected medical emergency arises or your dream home comes on the market, but the decision shouldn’t be taken lightly. 

Illiquid money

Once you put your money into an annuity, it’s generally tied up for an extended period. You’ll receive your income stream, and 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 don’t suffice.

Can be risky

Because they may rely entirely 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 to 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 route.

Variable annuities tend to have the highest fees too — a mortality and expense risk charge, the expense ratios of any funds you invest in, administrative fees and any additional fees for special riders you’ve added to the account (for example, a death benefit or guaranteed minimum payout.)

And suppose you withdraw your money early, before age 59 ½. In that case, you can get hit with a 10 percent bonus penalty from the IRS in addition to taxes you’ll owe on any investment gains, much like the penalties for early withdrawals from traditional IRA and 401(k) accounts.

Alternatives to annuities

So many kinds of annuities exist because consumers have varying needs. But ultimately, annuities aren’t suitable for everyone. Here are some alternatives to annuities:

• Investment portfolio: Strategic investments can help provide extra income during retirement. For example, while an annuity may promise you a 4 percent return on your money, a financial advisor may be able to construct a portfolio that earns you 5 percent today and offers a growing stream of dividends in future years. Or you could use a robo-advisor to create a balanced portfolio for you at a fraction of the cost.
• Managed payout fund: A managed payout fund is similar to an annuity, but there is no guaranteed rate of return on your money. Managed payout funds are a type of mutual fund that can yield anywhere from 1 percent to 8 percent growth.
• Life insurance policy: Certain types of life insurance can provide income replacement during retirement, usually through riders. Life insurance policies also have a death benefit that your loved ones can access after you pass away.

Frequently asked questions

• What are the benefits of purchasing an annuity?

  One of the most significant benefits of an annuity is that it allows you to put money away for retirement. The money grows tax-free, which maximizes the account’s growth potential. If you choose a fixed annuity, you will get a guaranteed rate of return on your money, which limits risk. Another benefit of annuities is that you can choose where to invest the money with a variable or indexed annuity. In that regard, an annuity may help diversify your investment portfolio depending on your financial situation.

• What is a surrender period?

  An annuity surrender period is the duration of time that an investor must wait to withdraw money from the account without being penalized. The surrender period depends on several factors, including your insurance company and the type of annuity. If you withdraw money during the surrender period, you will likely have to pay a hefty fee.

Bottom line

Annuities can be a good decision for the right person at the right time, but they come with substantial downsides that you should understand before signing a contract. Consider working with a financial advisor who can help you determine your long-term financial goals, investment strategy and help you decide if an annuity is the right fit for you. 

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.