What Is an Annuity? Here's What You Need to Know

What Is an Annuity? Here's What You Need to Know

Pop quiz: Do you even know what an annuity is?

In the financial world, they tend to get a bad rap, but there are a lot of different types of annuities, and if you’re considering investing in one, you need to know what you’re getting into. Annuities can be the right fit in specific situations, but they tend to be associated with high fees, so it’s important to educate yourself before you jump in.

Let’s start with the basics: An annuity is a contract between you and an insurance company in which the insurance company invests your money and promises to pay you a regular income, either now or at some point in the future, in exchange for a specified amount of money, which is paid to the insurance company in either a lump sum or a series of payments.

What are the benefits of an annuity?

One of the biggest reasons people like annuities is because they can provide a steady stream of income during retirement, similar to an income stream from a pension. Another reason people like annuities is because the money accrues on a tax-deferred basis, until the funds are withdrawn, like an IRA or 401(k).

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What are the different types of annuities?

  • Immediate: If you want an immediate annuity, you have to pay a lump sum, and then you begin receiving payments generally 30 days later (hence the immediate part), but you can wait up to a year. The size of the payments can vary according to many factors including: your age, the size of the lump sum payment, the terms of the contract (such as a specific number of years that you’re guaranteed payments vs. over your lifetime), etc. People often use immediate annuities at retirement to convert a specific amount of money into an income stream designed to cover some or all of their essential living expenses that aren’t covered by Social Security or a pension.
  • Deferred: A deferred annuity consists of two different phases: the first is the accumulation phase, and the next is the distribution phase. This type of annuity requires you to build up the funds over time before you decide to annuitize them. For example: You may contribute $500 every month, then, at retirement, you decide to convert the amount you have accumulated into an income stream (this is what it means to annuitize). You may also have the option to retain control of your funds and simply make withdrawals from the account as needed.

Within these two categories, annuities can also be fixed, variable or indexed.

Fixed: A fixed annuity means that the insurance company invests the money for you and guarantees a minimum interest rate similar to a CD interest rate at a bank (but unlike a CD, an annuity is not FDIC insured), but may also pay a higher interest rate for a specified period, such as one year or five years. They can be either immediate or deferred. Fixed annuities commonly have a period of time in which you are subject to penalties if you withdraw principal, often seven years. At the end of that surrender period, you may choose to extend your contract with the insurance company, cash it out (and pay income taxes on the gain), or convert to an income stream.

You can have them pay out over your lifetime or over a set number of years. One common example is: 10-Years period certain, which means that if you die within 10 years, let’s say after six years, the remaining four years of your annuity payments will be paid out to your beneficiary. Keep in mind that these payments are NOT indexed for inflation, so if you decide to opt for lifetime payments and live for another 30 years, the purchasing power would be eroded. For example: $500 in 1983 would have the purchasing power of $1,176 in today’s dollars.

  • Variable: These annuities differ from fixed annuities because, instead of getting a guaranteed interest rate, you can actually invest the money into a preselected list of funds called sub-accounts. These funds can range from aggressive stock funds to conservative bond funds, but keep in mind that these are not actual mutual funds.  This means that your returns will fluctuate rather than providing fixed returns. These types of annuities are often sold to people who are hoping to benefit from significant tax savings because the growth on the investment is deferred until the withdrawal phase. This allows you to exchange between different investment options and rebalance your portfolio without triggering taxation. However, there’s a catch, so keep reading about fees before taking the leap.
  • Indexed: An indexed annuity is like a combination of a fixed and variable annuity. You get to participate in some upside potential because it’s tied to an index (like the S&P 500), but generally it’s capped at a certain percent. However, you also get protection against downside risk with a guaranteed minimum (usually 2-3%).

What types of fees or charges are associated with annuities?

The fees on annuities can run upwards of 3% per year! Here are a few questions you will want to ask before purchasing an annuity:

  • Mortality and expense charges: This fee is charged for the insurance guarantee (most annuities will give at least your original investment back to your beneficiary, regardless of performance, if you die without reaching the payout phase, so naturally there is a cost for this), the administrative costs, and commission. It is usually given in basis points, and 100 basis points is equal to a 1% charge. (Also note: advisors make a very large commission off of selling an annuity to a client, so sometimes clients are pressured into buying annuities when there might be another investment that is a better fit. If you know that an annuity is not the right fit for you, you may want to work with a fee-only financial planner because this type of planner doesn’t sell annuities or any other commissioned products).
  • Surrender charges: This is the cost to get out of your current contract, and these fees can be extremely high. A typical surrender charge is 7% in the first year and goes down 1% each year until it reaches zero. A typical surrender period is between 6-8 years, therefore, you don’t want to invest in an annuity if you’re going to need to access your money before that time. In addition, keep in mind that the tax-deferred portion of your earnings will also be subject to an early withdrawal penalty by the I.R.S. if you cash out of the annuity prior to age 59 ½.
  • Management fees: This is the cost to own the subaccounts and is similar to the investment manager’s fees on a mutual fund.
  • Fees for additional riders: Annuities are becoming very complicated creatures, and now many advisors offer different “riders” that you can add for additional fees such as a “living benefit income rider” or “inflation rider.”

How do you know if an annuity might be the right fit for you?

  • Annuities tend to be a better fit for retirees or people nearing retirement who want a portion of their portfolio to be a guaranteed income stream. However, I don’t recommend putting more than 30% of your portfolio into an annuity in case a major emergency arises and you need access to money. You don’t want to have to pay the surrender charges to access your annuity.
  • If you are already maxing out your other retirement plans and you are looking to set aside more money to grow tax-deferred to be used for retirement, then you might want to consider an annuity, but there could be other options that fit your specific goals better than an annuity.
  • If you received a large inheritance or windfall and you want to lock up a portion of your money to be used as an income stream in retirement and do not want to have access to it, an annuity might be a good fit for you.

Who should NOT get an annuity?

  • If you’re not maxing out your current retirement plans, then you probably don’t need an annuity. Utilizing your 401(k) and Roth IRA will likely provide better benefits and be more cost effective than owning an annuity.
  • If you want to access your investment in the next five years, you’re better off with a high-yield savings account or CDs that are FDIC insured.

RELATED: 10 Things You're Embarrassed to Ask About Saving

Annuities can be really costly and oftentimes there are things that people should focus on first before considering annuities, such as building a solid financial foundation. In rare instances, they can be a good fit for a client by providing an income stream in retirement, but make sure you understand the risks and fees fully before you dive in.


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