How Do Annuities Work?
Annuities are investment products that give you guaranteed income in retirement. If you’re wondering “how do annuities work?,” keep reading.
February 24, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
When it comes to preparing for retirement, the majority of people will benefit from utilizing a variety of funding methods.
Many count on Social Security, the government program that pays seniors a monthly benefit. However, Social Security is only designed to replace about 40% of your typical income.
That means if you earn approximately $5,000 per month while working, your Social Security check may only be around $2,000 per month.
To cover the gap, many people turn to retirement savings vehicles like a 401(k), Roth IRA or other retirement accounts.
But there’s another option that may provide a beneficial piece to the retirement puzzle: annuities.
So, what are annuities? And how do annuities work?
What is an annuity?
An annuity is a financial product that is part investment, part insurance policy.
You can purchase an annuity through:
A one-time, lump-sum payment
Monthly payments over a period of time
In exchange, you’re paid a stream of income in the future.
Annuities provide a predictable source of income, which can be useful for retirement planning. They can also serve as a type of insurance against outliving your retirement savings.
There are several different types of annuities, and each style works in a slightly different way.
Additionally, there are both lifetime annuities and term annuities:
Lifetime annuities pay out until the death of the policyholder
Term annuities pay out for a predetermined period of time (i.e. 15 years)
Types of annuities
There are three different types of annuities:
Here’s what you need to know about each style.
Fixed annuities are popular and predictable, as they offer a set rate of interest regardless of what happens with interest rates or the performance of the stock market. They are less risky than variable annuities, but may have lower interest rates overall.
Immediate fixed-income annuities require an upfront lump-sum payment, and then immediately start paying a fixed amount of money each month. These are often more useful for people who are already retired or nearing retirement.
Deferred income annuities require an upfront payment or monthly payments, and start paying a fixed amount of money each month starting months or years after the initial purchase. They’re often preferred by those who are further out from retirement age.
Variable annuities are less predictable, as their payouts are largely based on the performance of investments. With a variable annuity, your contributions are invested in assets, such as stocks or mutual funds.
The amount of monthly income you receive from a variable annuity depends on two factors:
How much you contribute
How well your investments perform
Variable annuities will tend to offer better payouts than fixed annuities as long as the stock market does well during the accumulation period — but they’re a bit riskier.
An indexed annuity is like a hybrid between a fixed and variable annuity.
There are two components to the monthly payouts of indexed annuities:
A fixed amount that provides a consistent income stream
A variable payout that depends on the performance of the invested assets
How do annuities work?
Annuities work by taking an upfront lump sum of money — $100,000, for example — and investing it. This is handled by the insurance agency that sells the annuity. Depending on the type of annuity (fixed vs. variable), the investments may be more conservative (like bonds) or more aggressive (like stocks).
Some annuities are paid for through monthly payments rather than an upfront lump sum.
How do annuities work when it comes to receiving your investments back? Payouts are typically issued monthly, and begin either immediately after you purchase the annuity or after a certain period of time.
These monthly payments will continue either until the end of the predetermined period (i.e. 10 years), or upon the death of the annuity holder.
As you can see, there are several variables that go into how annuities work. Each product will work slightly differently, so it’s important to read the fine print and understand the full details of any annuity you’re considering.
Pros and cons of annuities
Like any financial product, annuities have both advantages and disadvantages — and they’re not necessarily for everyone.
Here’s what savers might keep in mind.
Can provide a predictable income stream
Can help you reduce the risk of outliving your retirement savings
Can supplement Social Security benefits and pensions/retirement savings
Deferred annuities can have favorable tax treatment
Fixed annuities are very predictable and provide a steady stream of income
Can be complex and difficult to understand
Can have high fees that eat into investment performance
Net returns on withdrawals are typically taxed as ordinary income
Lack of liquidity: Withdrawing early typically results in large fees
How do annuities work in your retirement plan — and do they deserve a place in your financial plan at all?
The answer to this question depends on your financial goals, your risk tolerance and the other investment options available to you.
It’s also important to look closely at the specific annuity you’re considering. You can weigh the pros and cons of annuities as a whole — but the reality is that each annuity product is different in its terms, fees and payments.
Retirement planning resources
Want to brush up on your retirement plans? Here are some useful resources to explore:
And, while you’re considering your financial health, it’s wise to keep debt in mind. Debt is like the opposite of an investment — it costs you money every month, in the form of interest, and it makes it harder to pursue your financial goals.
If you have existing credit card debt, you can look into Tally†. Tally is a powerful app, offering a lower-interest line of credit, that may help qualifying users pay off their credit card debt faster. Learn how Tally works here.
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