What is an Annuity? How Does it Work?

If you've started to research ways to generate income in retirement, you've likely encountered annuities. But what is an annuity? Is there one type of annuity, or many types to choose from? What are the basics of how annuities and annuity types work? In this article, we'll explore the different types of annuities, how much they cost, and more to help you decide if an annuity could make sense for you.

An annuity is a contract between an investor and an insurance company that can provide a unique combination of insurance and investment features. Annuities can complement other retirement plans and, depending on the annuity type, they may provide guaranteed lifetime income¹, guaranteed yield¹, market participation, downside protection, and legacy protection for your beneficiaries. The question of if you should consider an annuity and the type of annuity you should consider will depend on whether one or more of these potential benefits apply to you. 

If you decide on buying an annuity, you will either make a one-time payment or a series of regular payments to the insurer, depending on the contract. Some contracts have a flexible payment arrangement that allows you to pay as much as you want and as frequently as you want, within certain limits. Annuities can grow on a tax-deferred basis, meaning investors pay no taxes on the earnings until they receive payments or make withdrawals. The amount of potential growth can either come from a guaranteed interest rate or by market participation. However, it's important to remember that some annuities can be complex and may include annual fees or charges.

Like pension plans and Social Security, annuities offer the potential for guaranteed income¹ that can supplement money in stocks, bonds or other investments in a 401(k), IRA, or other retirement savings to help cover retirement needs. If the investor is ready to collect income, the annuity contract can begin paying out regular income for a set period of time, the owner’s lifetime, or the lifetime of the owner and a spouse. Income payouts are generally paid monthly. And the amount you receive depends on many factors, including premium amount, account balance, age, and the type of annuity you select.

Knowing when you want annuity payments to begin may help you determine which type of annuity to choose. An investor who wants to start receiving income right away might consider an immediate annuity. With a deferred annuity, the payments can start at a flexible or designated date in the future, which means your money has an opportunity to grow tax deferred and you won't pay taxes on any earnings until distributions begin.

Let's take a closer look at common types of annuities and how they work.

With these annuities, you typically give a lump sum in the form of a premium payment (purchase payment) to an insurance company, and in exchange you can receive income payouts. Another name for this type of annuity is a single premium immediate annuity (SPIA). Importantly, the premium payment is typically irrevocable—once you turn it over, you will not have access again to your premium.  

On the flip side, the company guarantees you a periodic payment, often for the rest of your life, or for the life of you and your spouse, regardless of future interest rates or market performance. These annuities are relatively straightforward and have no additional costs or fees and can work well in combination with a portfolio of investments.  

By giving up access to the premium, annuity owners receive a form of insurance.  That is, income payments will be paid, subject to the claims-paying ability of the insurance company, for as long as they live, no longer how long the contract owner lives or how markets perform. Annuity owners that live longer than the average person benefit from a portion of unused funds from other annuitants who do not. This concept is called “pooling,” to manage risk, and is essential to the benefit provided by most types of insurance, including income from annuities.

Deferred annuities generally make sense for savings intended for retirement, but for which the owner does not need income now. Most deferred annuities pay either a guaranteed interest rate or a return linked to an investment return that provides an opportunity to benefit from potential market growth while you wait to make any distributions from the annuity. 

In addition to paying a single upfront premium, investors in these annuities can also usually pay annual or monthly premiums. Taxes due on any growth of investments in a deferred annuity are generally delayed, or deferred, until the owner takes withdrawals or income from the annuity. At that time, withdrawals of the portion of the balance generated from investment growth is generally taxed as ordinary income. 

There are five common types of deferred annuities:

• Deferred income annuities allow you to choose a point in the future when you want the income payments to start, generally, this is at least 13 months out from the initial purchase. Other than that, they operate like immediate annuities. A strategy to reduce the impact of outliving your assets is to purchase a deferred income annuity, for example, in your 60s, and start taking income around age 85 (the longer time horizon increases the income potential). Deferred income annuities can be a form of longevity insurance, or protection. That said, you should take your life expectancy into account before implementing this or any strategy.
• Fixed deferred annuities (or FDAs) generally pay a guaranteed minimum fixed interest rate over a set period of time, that may change, depending on the contract, based on prevailing interest rates or other factors. This means that while you don't benefit anymore from a positive market performance, the rate of return won't generally decrease due to negative market performance either. After the rate period ends, you can generally choose to withdraw your money, exchange it into a new annuity, or renew it. If you renew it, the insurance company will set another interest rate for the new time period, which can be higher or lower.
• Fixed indexed annuities (aka FIAs) typically pay a return tied to the performance of a market index, like the S&P 500 index, but may not credit any return to you when the performance of the market is flat or negative. While FIAs can pay more handsomely in positive market years compared to a fixed deferred annuity or other more bond-like investments, they may underperform during years with little or poor market performance.
• Registered index-linked annuities (RILAs) are a type of indexed annuities designed for investors who are more comfortable with taking on additional market risk than a FIA. RILAs allow for greater potential growth tied to a market index, but in exchange, provide a limited level of protection ("buffer") in negative market years. In other words, the investor could see their principal decline if the market falls below the elected buffer protection level defined by the RILA. 
• Variable annuities allow you to put money in underlying investments that can go up or down in value. While the principal in the investments may not be guaranteed, variable annuities may have some income protection, called guaranteed withdrawal benefits (or riders), but for an additional cost. Variable annuities generally give you the greatest market exposure versus the other deferred annuities above, which may increase market risks and returns.

Indexed annuities such as FIAs and RILAs are generally more complex than SPIAs, deferred income, or fixed deferred annuities, in part because of their complex interest crediting rules tied to the market index. So, before choosing a specific annuity, it's best to clearly understand how the annuity can grow and what protections it may have to limit negative returns in the market.

Deferred annuities also generally offer a variety of optional features. Known as riders, these features may include guaranteed lifetime withdrawals benefits (also called "living benefits"), death benefits, and long-term care conversion benefits, each of which comes with an annual fee. 

While all annuities allow you to convert your assets into a series of periodic payments (annuitization) for life or a specific period of time without an additional cost, FIAs, RILAs and variable annuities typically offer an optional guaranteed lifetime withdrawal benefit that doesn't require you to give up complete control of your assets. In exchange for this flexibility, the provider may impose surrender charges—that is, early withdrawal fees—or may reduce income benefits if you withdraw more than a certain amount each year.

If you choose and pay for an optional living benefit rider, you may be able to take a guaranteed withdrawal amount every year for as long as you, or you and your spouse, are alive, regardless of how the market performs or the account balance. Again, it's critical to understand and ask as many questions as you need to understand the details and costs.

As with income annuities, the guarantees associated with different indexed and variable annuities, along with any optional riders purchased, are subject to the financial strength and claims-paying ability of the issuing insurance company.

Also, it's helpful to know that any growth of your original principal, when withdrawn, will be taxed as ordinary income and may be subject to an early withdrawal penalty if taken before age 59½.

The cost of an annuity depends on which kind you're considering. Income annuities and fixed deferred annuities often do not have explicit fees or costs. The annuity companies' “fee” is built into their actuarial estimates of longevity of their pool of annuity purchasers, projected market returns, mortality credits, and other factors. 

Fixed indexed annuities, registered index-linked annuities, and variable annuities often charge an additional cost for any optional benefits elected, including living benefit riders, making them potentially more expensive. For example, a fixed indexed annuity with a guaranteed lifetime rider can range from 1% to 3% of the contract value. Though the average cost of a variable annuity is 2.3%, costs can exceed 3%.

In general, the more features an annuity has, the higher the expenses. Research from Annuity.org gives a range of annuity expenses:  

• Commissions, paid to the annuity's seller, range from 1% to 8%.
• Administrative fees average 0.3% per year.
• Mortality expenses, to cover the insurance risk, range from 0.5% to 1.5%.
• Surrender charges, for early withdrawal, cost up to 10% of the contract's value.
• There are additional investment expenses for variable annuities.

Commissions and fees are generally built into the annuity contract, so the consumer isn't paying them directly, but they can potentially affect returns. Before purchasing it is appropriate to ask the annuity representative or your advisor how—and how much—they're paid, for the types of annuities they recommend, as well as what effect commissions and other fees have on returns.

Every benefit you receive from an annuity can have a commensurate risk, tradeoff, or real or potential cost—in some cases, several. So, make sure you ask questions about the risks and tradeoffs based on the benefits your annuity offers. While you gain the benefit of guaranteed monthly payments with a SPIA, for example, you give up access to your money and potential growth. In addition, your purchasing power is likely to decline over time (unless you pay extra for an inflation-adjustment option).

When considering annuities and whether a particular type of annuity fits your needs, do so in the context of all your retirement income, savings, investments, and assets, and determine which purpose each income stream will serve. You'll probably already have one form of lifetime guaranteed income—regular payments from either Social Security or a government pension—and that might be enough to satisfy your need.

But if you're concerned about outliving your savings and want a higher level of guaranteed income that doesn't depend on the stock market or other investments, one strategy might be to allocate a portion of your retirement savings to a SPIA and invest the rest in a portfolio of investments. A combination of annuity payouts and portfolio can be particularly helpful if what you receive from Social Security or a pension doesn't meet your financial needs.

Another approach is to purchase a deferred income annuity that begins to pay out only later in life. This requires a smaller investment, usually 5% to 10% percent of your savings, and helps protect against the risk of outliving your portfolio. Here again, you'll be able to diversify the remainder of your savings in a way that allows for liquidity, additional income, and growth potential—and feel more confident in drawing money from your portfolio sustainably early in retirement.

Indexed and variable annuities that may have optional living benefits can also work with your existing sources of retirement income and portfolio, but these can be more complex and warrant additional questions. Make sure you understand the details before you buy.

Regardless of the strategy you choose, it's reasonable to use predictable and—if possible—guaranteed income sources to cover essential expenses in retirement such as for food, housing, and utilities. Then, look to your portfolio to fund more flexible or discretionary expenses. If you understand the details, having a baseline of income from an annuity in combination with your investments can provide the combination of protection, flexibility, and potential for growth you need to enjoy retirement

Use this checklist to get the following information from the person selling the annuity before you buy:

• How are you compensated?
• Do you offer other options for retirement income?
• What is the insurance company's financial strength rating?
• What fees should I expect to pay with this annuity?
• What happens to my money when I die?

There are other ways to manage retirement income that leverage your entire portfolio and provide similar or complementary benefits:

• Automated portfolios offer predictable, systematical but annually monitored withdrawals from a portfolio of investments. This approach provides flexibility and access to funds, but no guarantees on payments for life.  
• Use a combination of assets such as bonds, CDs, and income-producing funds with or without personalized guidance from professional financial advisor.  This approach may provide a generally predictable income stream, but less growth potential than a diversified portfolio and without guaranteed payments for life.  

The choice to purchase an annuity for income in retirement, generally doesn't need to be, and shouldn't be, an all or nothing decision. If used well and for a particular need or purpose with knowledge of tradeoffs and fees, certain types of annuities may combine well with investments and other money management strategies to create a diversified retirement income plan.  

As always, we suggest making decisions in the context of a personalized financial plan, working with a trusted comprehensive planner or planning professional.