What Is an Annuity and How Does It Work?

What Is an Annuity?

An annuity is a series of payments made at equal intervals. Examples of annuities are regular deposits to a savings account, monthly home mortgage payments, monthly insurance payments, and pension payments. Annuities can be classified by the frequency of payment dates.

The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other regular interval of time. Annuities may be calculated by mathematical functions known as “annuity functions”. An annuity that provides for payments for the remainder of a person’s lifetime is a life annuity.

Also, the term “annuity” refers to an insurance contract issued and distributed by financial institutions with the intention of paying out invested funds in a fixed income stream in the future. Investors invest in or purchase annuities with monthly premiums or lump-sum payments.

The holding institution issues a stream of payments in the future for a specified period of time or for the remainder of the annuitant’s life. Annuities are mainly used for retirement purposes and help individuals address the risk of outliving their savings.

What Is an Annuity and How Does It Work

How do annuities work?

An annuity is a long-term investment that is issued by an insurance company and is designed to help protect you from the risk of outliving your income. Through annuitization, your purchase payments (what you contribute) are converted into periodic payments that can last for life.

Nationwide’s annuities are flexible, so you can choose one that enables you to:

  • Invest a lump sum or invest over a period of time
  • Start receiving payments immediately or at some later date
  • Select a fixed, variable or indexed rate of return

Investing involves risk, and your investments may lose value. All guarantees and protections are subject to the claims-paying ability of the issuing insurance company, but the guarantees do not apply to any variable accounts, which are subject to investment risk, including the possible loss of principal.

How Do Fixed Annuities Work? Fixed annuities work by providing periodic payments in the amounts specified in the contract. If your contract says the payout rate is 5 percent on a $100,000 annuity, for example, then you will receive $5,000 worth of payments every year covered by the contract.

How Does a Variable Annuity Work? Variable annuities have payout rates that vary, depending on the performance of an investment portfolio. The amount you receive in payments depends on how much money the portfolio gains or loses. This is riskier, but also has the potential of paying you more.

Are Annuities a Good Idea?

Whether annuities are a good idea depends on your circumstances, your needs, and whether the particular annuity type is a good fit.

If you already have a healthy pension or another source of income sufficient to support your everyday needs in retirement, you may not need an annuity.

If you don’t have a guaranteed stream of retirement income, you should consider buying an annuity. An annuity is a good source of lifetime income.

Types of Annuities

There are four basic types of annuities to meet your needs: immediate fixed, immediate variable, deferred fixed, and deferred variable annuities. These four types are based on two primary factors: when you want to start receiving payments and how you would like your annuity to grow.

When you begin receiving payments – You can either receive your annuity payments immediately after paying the insurer a lump sum (immediate) or receive monthly payments in the future (deferred).

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How your annuity investment grows – Annuities can grow in a couple of different ways – through interest rates (fixed) and by investing your contributions in the market (variable).

1. Immediate Annuities: The Lifetime Guaranteed Option

One of the trickier elements in retirement income planning is figuring out how long you’re going to live. Immediate annuities are designed specifically to provide an immediate guaranteed lifetime payout.

The drawback is that you’re trading liquidity for guaranteed income – so you generally won’t have access to that full lump sum if you need it for emergencies. But if securing lifetime income is your top concern, then a lifetime immediate annuity could be the right option for you.

What makes immediate annuities so appealing is that the fees are woven into the payout – you contribute a certain amount of money, and you know exactly how much money you will be receiving for the future, for the rest of your life, and your spouse’s life.

Financial organizations like Thrivent that offer immediate annuities typically offer additional income payout options, like recurring payments over a fixed term, or until you die. You may also have an optional death benefit, where you can have payments sent to people and causes of your choosing.

2. Deferred Annuities: The Tax-Deferred Option

Deferred annuities provide guaranteed income in the form of a lump sum or monthly income payments on a date in the future. You pay a lump sum or monthly premiums to the insurer, who will then invest them into the growth type you agreed on – fixed, variable, or index (we’ll get to those in a minute). Depending on the investment type you choose, deferred annuities offer the potential for the principal to grow before receiving payments.

Deferred annuities are a great option if you want to contribute your retirement income on a tax-deferred basis – meaning you won’t have to pay taxes until you take money out. Unlike IRAs and 401(k)s, there are no contribution limits.

3. Fixed Annuities: The Lower-Risk Option

Fixed annuities are the simplest type of annuity to understand. The insurance company gives you a guaranteed fixed interest rate on your investment when you agree to the length of your guarantee period. That interest rate could last anywhere between a year and the full length of your guarantee period.

When your contract is over, you can either annuitize your contract, renew your contract, or transfer your money into another annuity contract or retirement account.

Because fixed annuities are based on the guaranteed interest rate and your income is not impacted by market volatility, you will know exactly how much your monthly payments will be but it also won’t benefit from a potential upswing in the market, so it may not keep pace with inflation. Fixed annuities are better used for growing income in the accumulation phase, not for generating income in retirement.

4. Variable Annuities: The Highest Upside Option

A variable annuity is a type of tax-deferred annuity contract that allows you to invest your money into sub-accounts, kind of like a 401(k), plus the annuity contract that can guarantee lifetime income. With time, your sub-accounts can help you keep up with or even outpace inflation.

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Like mutual funds, sub-accounts are dependent on market risk and performance. Fortunately, variable annuities also come with a death benefit, an income rider that your beneficiaries are guaranteed income, too. Additionally, Thrivent’s guaranteed lifetime withdrawal benefit helps protect against longevity risk and market risk. The double protection can be very appealing if you are 15 years or less to retirement.

A variable annuity can be a great addition to your retirement income plan if you’ve already maxed out your Roth IRA or 401(k) contributions and would like the comfort and confidence of guaranteed income – so you can focus on your goals knowing you won’t outlive your money.

5. Long-Term Care Annuities

A long-term care annuity is a tax-deferred fixed contract that provides an enhanced tax-free benefit to supplement qualified long-term care services and facilities.

6. Two-Tiered Annuity

A two-tier annuity is a tax-deferred FIA contract where you invest money upfront, grow your investment during the accumulation period, and annuitize your future contract values into an irrevocable guaranteed income stream. Annuitization is required.

7. Qualified Longevity Annuity Contract (QLAC)

A QLAC is a Deferred Income Annuity (DIA) is a deferred income annuity type funded specifically by qualified retirement savings plan to defer Required Minimum Distributions (RMD).

8. Structured Settlement

A Structured Settlement is a structured, irrevocable series of periodic payments from an insurance company commonly court-ordered similar to an SPIA.

9. Secondary Market Annuity

A secondary market annuity resells an annuitized distribution (guaranteed income stream payments) in exchange for a lump sum now.

10. The Medicaid Annuity

A Medicaid Compliant Annuity is a unique SPIA meant to maintain a healthy elderly spouse’s lifestyle financially while their unhealthy spouse receives Medicaid.

11. The Charitable Gift Annuity

A charitable gift annuity is a transfer by a donor to a charitable organization. In return, the donor receives annuity payments. If the actuarial value of the annuity is less than the value of the donation, then the difference in value is declared a charitable deduction for federal tax purposes. The annuity payments to the donor are tax-free partial returns based on actuarial tables of life expect

12. Registered Index-Linked Annuity

The Registered Indexed-Linked Annuity is a hybrid of the fixed indexed and variable annuity. When an index performance is positive, the annuity may earn interest, limited by a cap or participation rate. Conversely, if the index performance declines, the annuity will earn zero interest and can lose value up to a “floor.”

The Pros of An Annuity

  • Guaranteed Income: The objective is to ensure that the investor receives a steady stream of retirement income. Customers may use one of these retirement plans as an add-on to their regular pay during retirement, much like they would while working. The client adds the payment on top of his or her Social Security check. The customer will receive a guaranteed income for a period of time or until death do us part.
  • Tax-Deferred Growth: Annuities are a type of investment that grows tax-deferred, which means the retirement savings plan is not taxed until you take money out. All of these pension programs provide the same advantage: tax deferral. Tax deferral simply refers to a benefit offered by the IRS that allows taxpayers to postpone paying taxes until they withdraw funds for personal use. Annuity income is taxable when received.
  • Long Term Care Insurance: To help offset the ever-increasing expense of long-term care, insurance companies have created supplements and riders. A few firms have even developed deferred annuities to provide tax-free payments to pay for nursing homes, assisted living facilities, and home healthcare.
  • Customizable Retirement Plans: Annuities, as with any commodity contract, can be tailored to fit the needs of the buyer. Notable benefits: Guaranteed income for life with or without inflation protection, pays for long-term care expenses, Enhances an inheritance for beneficiaries, Automated Money Management Assistance
  • Automated Money Management Assistance: A guaranteed minimum income benefit rider can distribute a portion of an investor’s retirement savings throughout their retirement, relieving the worry and stress of running out of money. This rider can provide income for either an individual or a married couple.
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The Cons of Annuities

  • High Fees: Insurance-based annuities can charge fees for additional add-on benefits. Variable annuity contracts can charge both benefit and annual maintenance fees.
  • Surrender Charges: Annuity owners who want to withdraw money from the annuity before a certain period (typically 2 to 10 years) have matured, often subject to heavy surrender fees.
  • Annuities with Extra Liquidity: Research annuities that offer extra liquidity to access your money when you need it, then request a quote.
  • Tax Penalties: If you are under the age of 59½, you may also have to pay an additional 10% early withdrawal penalty on any money taken out.

FAQs.

What is an annuity in simple words?

An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.

How does an annuity work?

Annuities are essentially insurance contracts. You pay a set amount of money today, or overtime, in exchange for a lump-sum payment or stream of income in the future. The type of annuity and the details of the particular annuity can determine the payouts you’ll receive.

What do you mean by annuity?

An annuity is a plan that helps you to get regular payment for life after making a lump sum investment. The life insurance company invests the money of the investor and pays back the returns generated from it.

Is an annuity a good investment?

Annuities are a good investment for people wanting a reliable income stream during retirement. Annuities are insurance products, not an equity investment with high growth. This makes annuities a good balance to a financial portfolio for someone near or in retirement.

What are the 4 types of annuities?

There are four basic types of annuities to meet your needs: immediate fixed, immediate variable, deferred fixed, and deferred variable annuities. These four types are based on two primary factors: when you want to start receiving payments and how you would like your annuity to grow.

Who should not buy an annuity?

You should not buy an annuity if Social Security or pension benefits cover all of your regular expenses, you’re in below-average health, or you are seeking high risk in your investments. Take our quiz here to decide if an annuity makes sense for you.