What Are Annuities and How Do They Work?

Annuities are unique retirement savings tools. The basic goal of an annuity is not all that different from other retirement savings options like a 401(k) or IRA. You invest money today that you’ll be paid (often in increments) when you retire. That’s about where the similarities end.

You pay the insurance company for an annuity, and they agree to pay out either a single lump-sum payment or an income stream at some future date.

You will usually need to pay premiums to keep the annuity active and to fund it. How much you’re paid in the future will depend on how much money you put in at the start, the premiums you pay and how well the funds are invested. 

Variable Annuities Versus Fixed Annuities

There are several types of annuities. Some are similar to investment accounts while others resemble fixed income investment products like a CD or bond.

For a fixed annuity, you generally pay the insurance company a lump sum (known as a premium payment) and they will either pay you interest on your premium payment or they will pay you out an income stream for a set period, or potentially the rest of your life. Whether you receive interest, an income stream, or both depends on the type of fixed annuity and whether you have elected to convert the cash accumulation value to a series of payments.

There’s a variation of fixed-income annuities known as deferred income annuities. These earn interest until a specific date, after which the annuity starts paying an income stream. The years of deferral is what’s known as the accumulation period, because the annuity accumulates interest during that time. In many cases, annuity holders can add more money in during this accumulation period and treat it like a high-interest savings account.

Variable annuities are similar to other retirement accounts where the money you pay into the annuity will be invested and the future income stream of the annuity will be entirely based on how the investment performs. This tax-deferred investment option that may be attractive to people who either don’t have a 401(k) or IRA or to retirement savers who want to invest more than their annual contribution limits in those other savings plans.

One of the key features of annuities are their estate planning features. The standard death benefit for the majority of annuities is at least cash value. Many even offer the premium payment as the minimum guaranteed death benefit.

Insurance companies offer clients dozens of professionally managed variable annuity investment options, providing investors options to help them balance their risk of loss with their growth potential. Fund categorizations will generally be familiar to anyone who invests in a 401(k) or other retirement accounts, with various small, mid and large-cap funds, growth funds, market-specific index funds, and other options.

Another type of annuity is an index annuity, or fixed-index annuity as it is often referred. Index annuities are a type of fixed annuity that provides investors with interest crediting strategies tied to one or more market-based indexes. While the index annuity policy holder will not be invested directly in the market represented by the index, their returns will vary based on the performance of the designated index. The amount of interest credited to the policy holder will depend on the performance of the index as well as the interest crediting methodology being used.

Some index annuities offer policy holders interest based on the percentage of the return of the index, (e.g. interest equal to the percentage return of the index, up to a cap), during the period; while others offer policy holders a defined percentage of the returns of the index, called a participation rate. Similar to traditional fixed-deferred annuities, index annuities generally offer policy holders a minimum account value and the option to convert their annuity into an income stream.

Why Would You Invest in an Annuity?

Some investors wonder what the point of annuities is. They may attempt replicate the effects of an annuity by investing in fixed income savings products like bonds or CDs or by investing in other retirement plans like a 401(k) or IRA.

One feature many soon-to-be retirees appreciate is the income stream. There are a variety of reasons why having a guaranteed income stream in retirement is valuable. You might have a significant nest egg saved up, and you may even be confident it will last you for decades. However, people are living longer, and unexpected costs can arise in retirement, like a medical emergency or needing specialized memory care for yourself or your spouse.

If other retirement savings run low, an annuity may continue paying a reliable income stream indefinitely (depending on the type and the payment period stipulated in the contract). There’s virtually no other retirement savings product – other than Social Security and, for some people, a pension – that will be guaranteed to pay you for as long as you live.

Reasons Why Annuities Are Risky

The one caveat to the money-for-life benefit of annuities is it assumes the insurance company stays in business. While in current times it’s rare for major insurers to go under, it could happen and could negatively impact any guarantees offered by the insurance company. However, all fifty states maintain guarantee funds aimed to protect policy holders from insurer insolvencies. (For example, the Arizona Department of Insurance and Financial Institutions has the Arizona Insurance Guaranty Funds.)

The benefits that annuities offer is not free. Some annuities may come with steep fees that may be pricier than other retirement savings alternatives. Examples include:

• Contract fees
• Rider fees
• Surrender charges
• Investment management fees

And, with any risk-mitigating investment option, there is typically an opportunity cost associated, especially fixed annuities. You might earn better returns by investing in other alternatives.

Should You Invest in an Annuity?

Every investor’s situation is different, which means there’s no one-size-fits-all solution. For some investors, holding annuities in a diverse retirement savings portfolio may make sense.

Call us at (623) 974-0300 to speak with a financial advisor at Fullerton Financial Planning about annuities and whether they’re right for you.