What They Are, Types, and How They Work

What Is an Annuity?

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.

How an Annuity Works

Annuities are designed to provide a steady cash flow for people during their retirement years and to alleviate the fears of outliving their assets. Since these assets may not be enough to sustain their standard of living, some investors may turn to an insurance company or other financial institution to purchase an annuity contract.

As such, these financial products are appropriate for investors, who are referred to as annuitants, who want stable, guaranteed retirement income. Because invested cash is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs to use this financial product.

An annuity goes through several different phases and periods. These are called:

• The accumulation phase, the period of time when an annuity is being funded and before payouts begin. Any money invested in the annuity grows on a tax-deferred basis during this stage.
• The annuitization phase, which kicks in once payments commence.

These financial products can be immediate or deferred. Immediate annuities are often purchased by people of any age who have received a large lump sum of money, such as a settlement or lottery win, and who prefer to exchange it for cash flows into the future. Deferred annuities are structured to grow on a tax-deferred basis and provide annuitants with guaranteed income that begins on a date they specify.

Annuity products are regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Agents or brokers selling annuities need to hold a state-issued life insurance license, and also a securities license in the case of variable annuities. These agents or brokers typically earn a commission based on the notional value of the annuity contract.

Special Considerations

Annuities usually have a surrender period. Annuitants cannot make withdrawals during this time, which may span several years, without paying a surrender charge or fee. Investors must consider their financial requirements during this time period. For example, if a major event requires significant amounts of cash, such as a wedding, then it might be a good idea to evaluate whether the investor can afford to make requisite annuity payments.

Contracts also have an income rider that ensures a fixed income after the annuity kicks in. There are two questions that investors should ask when they consider income riders:

1. At what age do they need the income? Depending on the duration of the annuity, the payment terms and interest rates may vary.
2. What are the fees associated with the income rider? While there are some organizations that offer the income rider free of charge, most have fees associated with this service.

Many insurance companies will allow recipients to withdraw up to 10% of their account value without paying a surrender fee. However, if you withdraw more than that, you may end up paying a penalty, even if the surrender period has already lapsed. There are also tax implications for withdrawals before age 59 and a half.

Because of the potentially high cost of withdrawals, some hard-up annuitants may opt to sell their annuity payments instead. This is similar to borrowing against any other income stream: the annuitant receives a lump sum, and in exchange gives up their right to some (or all) of their future annuity payments.

Individuals who invest in annuities cannot outlive their income stream, which hedges longevity risk. So long as the purchaser understands that they are trading a liquid lump sum for a guaranteed series of cash flows, the product is appropriate. Some purchasers hope to cash out an annuity in the future at a profit, however, this is not the intended use of the product.

Types of Annuities

Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. As mentioned above, annuities can be created so that payments continue so long as either the annuitant or their spouse (if survivorship benefit is elected) is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.

Immediate and Deferred Annuities

Annuities can begin immediately upon deposit of a lump sum, or they can be structured as deferred benefits. The immediate payment annuity begins paying immediately after the annuitant deposits a lump sum. Deferred income annuities, on the other hand, don’t begin paying out after the initial investment. Instead, the client specifies an age at which they would like to begin receiving payments from the insurance company.

Depending on the type of annuity you choose, the annuity may or may not be able to recover some of the principal invested in the account. In the case of a straight, lifetime payout, there is no refund of the principal–the payments simply continue until the beneficiary dies. If the annuity is set for a fixed period of time, the recipient may be entitled to a refund of any remaining principal–or their heirs, if the annuitant has deceased.

Fixed and Variable Annuities

Annuities can be structured generally as either fixed or variable:

• Fixed annuities provide regular periodic payments to the annuitant.
• Variable annuities allow the owner to receive larger future payments if investments of the annuity fund do well and smaller payments if its investments do poorly, which provides for less stable cash flow than a fixed annuity but allows the annuitant to reap the benefits of strong returns from their fund’s investments.

While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to annuity contracts—usually for an extra cost. This allows them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value.

Other riders may be purchased to add a death benefit to the agreement or to accelerate payouts if the annuity holder is diagnosed with a terminal illness. The cost of living rider is another common rider that will adjust the annual base cash flows for inflation based on changes in the consumer price index (CPI).

Criticism of Annuities

One criticism of annuities is that they are illiquid. Deposits into annuity contracts are typically locked up for a period of time, known as the surrender period, where the annuitant would incur a penalty if all or part of that money were touched.

These periods can last anywhere from two to more than 10 years, depending on the particular product. Surrender fees can start out at 10% or more and the penalty typically declines annually over the surrender period.

Annuities vs. Life Insurance

Life insurance companies and investment companies are the two primary types of financial institutions offering annuity products. For life insurance companies, annuities are a natural hedge for their insurance products. Life insurance is bought to deal with mortality risk, which is the risk of dying prematurely. Policyholders pay an annual premium to the insurance company that will pay out a lump sum upon their death.

If the policyholder dies prematurely, the insurer pays out the death benefit at a net loss to the company. Actuarial science and claims experience allow these insurance companies to price their policies so that on average insurance purchasers will live long enough so that the insurer earns a profit. In many cases, the cash value inside of permanent life insurance policies can be exchanged via a 1035 exchange for an annuity product without any tax implications.

Annuities, on the other hand, deal with longevity risk, or the risk of outliving one’s assets. The risk to the issuer of the annuity is that annuity holders will survive to outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.

Example of an Annuity

A life insurance policy is an example of a fixed annuity in which an individual pays a fixed amount each month for a pre-determined time period (typically 59.5 years) and receives a fixed income stream during their retirement years.

An example of an immediate annuity is when an individual pays a single premium, say $200,000, to an insurance company and receives monthly payments, say $5,000, for a fixed time period afterward. The payout amount for immediate annuities depends on market conditions and interest rates.

Annuities can be a beneficial part of a retirement plan, but annuities are complex financial vehicles. Because of their complexity, many employers don’t offer them as part of an employee’s retirement portfolio.

However, the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law by President Donald Trump in late December 2019, loosens the rules on how employers can select annuity providers and includes annuity options within 401(k) or 403(b) investment plans. The easement of these rules may trigger more annuity options open to qualified employees in the near future.