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Annuities Explained: What Is an Annuity and How Does it Work?

Everybody knows about a checking account, advantages of a savings account or how to buy a certificate of deposit. However, if you ask them what an annuity is, you will probably get some shrugs. Annuities are often misunderstood, so in this article we’re going to cover the basics of how an annuity works, how to buy an annuity, and whether an annuity is right for you.

What is an Annuity?

An annuity is an insurance contract that provides a guaranteed stream of income for a specified amount of time or life. A guaranteed steady stream of income is the holy grail of financial planning, so why isn’t everyone flooding insurance companies to buy an annuity? Because any type of “guarantee” comes at a high cost and not everyone will need a guarantee.

A financially savvy person saving responsibly for his/her retirement might be able to self-insure. On top of that, annuities are complex and there are different varieties of annuities with hundreds of options, riders, disclaimers, footnotes and contingencies.

Different Types of Annuities

There are two basic types of annuities – immediate and deferred.

  1. Immediate annuity – If you need a guaranteed stream of income right away, you can convert a lump sum to an immediate annuity that pays out monthly, quarterly or annually. You can opt to get payments for a fixed number of years or until you die. Yes, if you have retirement savings, you can start drawing down from that but there is always the risk of running out of money if the money is no longer growing with inflation.
  2. Deferred annuity – If you are years away from your retirement and want to make sure you have a guaranteed income source in retirement, you can get a deferred annuity. The cash you invest grows tax deferred within the annuity (similar to your 401k) to receive payments at a later date.

Each of these can have multiple options – single premium, flexible premium, fixed annuity, variable annuity, life income annuity, joint annuity, equity-indexed annuity, to name a few.

Annuity Options

Purchasing an annuity isn’t as easy as deciding whether or not you simply want an immediate annuity or deferred annuity. Below are a few of the options you need to consider:

  • Single premium – You buy an annuity using a lump sum.
  • Flexible premium – you pay multiple premiums to the company.
  • Fixed – Your money will earn a fixed interest rate set by the insurance company. When you begin receiving income, a fixed payment is guaranteed.
  • Variable – Your money will be split into sub-accounts depending on your risk level, and be invested in stocks, bonds or other investments. The annuity pays a minimum income which could go up depending on performance, but the downside is these typically have substantially higher fees than mutual funds.
  • Equity-Indexed – A variation of a fixed annuity where the interest rate is based on an outside index, such as a stock market index. Similar to variable annuity this product pays a minimum rate which might go up if the index performs better.
  • Life income – You receive income as long as you live, even if payments exceed the amount of money you put into the annuity. If you buy an installment refund rider your beneficiaries will continue to receive payments even after you die until the total amount paid to you and your beneficiaries equals the premium. If you didn’t buy any rider, the insurance company will keep the money.
  • Joint and life income – Provides income as long as you or the survivor live.

The Advantages of an Annuity

Annuities offer two types of benefits – tax-related and investment-related.

  • The “sleep at night” factor: Average life expectancy in the U.S. is getting longer and longer. So, it’s no surprise that a top worry for people saving for retirement is that they might outlive their savings. Annuities are supposed to be a solution to that. With the right annuity, you can get a guaranteed stream of income, however long you live. Sometimes, people feel that simply having the peace of mind that they’ll always have a source of income makes annuities worth a look.
  • Control risks: A variable annuity will let you take risks (via the underlying investment options) while giving you some control of the outcome (via the option of guaranteed minimum income). So, in a way, it lets you take financial risk and reduce it at the same time. For example, if you get a variable deferred annuity with minimum income, you can get the peace of mind that you will receive $x no matter how you invest the money in the annuity. If your annuity’s performance is great you will receive $y (>$x) for life. If the performance is poor, you will still receive the $x promised for life.
  • Tax deferral: When you buy a deferred annuity, the earnings are tax-deferred, which means that you don’t pay tax on the growth of the investments until you start making withdrawals. If you’re in a high tax bracket now and expect to be in a low tax bracket at retirement, this can add a good chunk of money to your nest egg.
  • Unlimited contributions – Unlike tax-advantaged accounts like IRAs or 401ks, there is no yearly contribution limit for an annuity. Qualified annuities allow you to sock away a large amount of cash and defer paying taxes. This can be especially beneficial if you are nearing retirement and have to catch up, or if you’re in a high tax bracket now but who expect to be in a lower tax bracket during retirement. And yes, if you hit the megamillions jackpot, you can invest that in an annuity and postpone the day Uncle Sam knocks on your door.

Disadvantages of an Annuity

The major disadvantage of an annuity is that they are too costly for the benefits they provide. Below is a laundry list of costs that come with annuities.

  • Mortality and expense risk fee (M&E fee): This is the major fee (can be anywhere from .5 – 1.5% of the policy value per year) which pays for the carrier to assume the risk that you and other annuity owners will live longer than expected.
  • Annual contract fee: This fee might be a fixed dollar amount or an expense ratio. For high value annuities, this fee might be waived.
  • Investment management fees: This is similar to the management fees you would pay an investment manager if he manages your investments. Variable annuities can have a lot of subaccounts, each of them holding a different investment. Similar to mutual funds, if the investments are index funds or exchange trade funds, the fees are lower. If they are actively managed funds, the fees can be very high. You will also pay the underlying fund expense ratio.
  • Optional rider fees: You can add a lot of riders to your annuity like guaranteed living benefits for deferred variable annuity or long-term care insurance. Each of these riders will cost money.
  • Commissions: When you buy an annuity through a broker, you’ll pay a commission. The commissions can range from 1% to 10% depending on the product (the longer the surrender period, the higher the commission). Even if the broker tells you that there are no fees, read the prospectus thoroughly, it might be built into the annuity. Sometimes, this is included in the M&E fees, sometimes it’s not.
  • Withdrawal or Surrender charges: Penalty/fees for taking out part or all of the cash value of the annuity prior to a specified date. If you invest the money and want to take it out before this date, you might lose a major portion of your money.

In addition to the expense, here are some other disadvantages of annuities:

  • You already own an income annuity – It’s called Social Security. If you’ve worked and paid payroll taxes in the United States for at least ten years (or forty quarters) you own an annuity from the Social Security Administration. If you’re still in the workforce, you own a deferred annuity. If you’re 65 or older, you can start taking payments immediately, which means you own an immediate annuity.
  • Reduced liquidity – Annuities are meant to provide a guarantee, and for that guarantee you are giving up the access to your money for a certain period of time. The more generous the guarantee, the longer you’ll relinquish access. If you want to get your hands on the money, you’ll find out that annuity contracts have a lot of fees and penalties that might shrink your investments drastically.
  • Annuity taxation – When you start taking payments from your annuity, those payments are taxed as ordinary income. In contrast, if you owned mutual funds or stocks, you’d pay the long-term capital gains rate on the earnings. The current ordinary income tax rate ranges from 10% to 37% depending on your income, whereas the long-term capital gains tax rate are 0%, 15%, or 20% depending on your taxable income and filing status. This can make a huge difference!
  • Lack of transparency – Annuities are a very complex insurance product. You have to spend a lot of time and effort on research to make sure you’re buying the right product for your needs, otherwise you might wind up with something totally wrong for you.

Should You Get an Annuity?

You shouldn’t consider getting an annuity if you’re not already taking maximum advantage of any tax-advantaged accounts available to you (like a 401k or IRA) because they provide the same tax advantage without as many fees. If, after you’ve maxed out all your tax-advantaged accounts and have carefully considered the high cost of annuities, you are still curious about them, there are a couple of scenarios where it might make sense to ask your financial advisor whether an annuity might be right for you:

  • You are in high tax bracket: If you are in a high tax bracket and have money left over to set aside for retirement, parking all of that in mutual funds means that you’ll have to pay tax every year on those earnings. Depending on your goals, you might want to consider an annuity to set aside money tax deferred. Do the calculation to see what’s more beneficial to your situation – paying taxes or paying the cost of the annuity.
  • You really would like to have a pension and don’t mind paying for one: If you have low expenses and decent retirement savings but the idea of a pension really appeals to you, you might want to talk to a financial adviser to see if converting part of your savings to an income annuity makes sense.
  • The worry of running out of money during your retirement keeps you up at night: You believe the U.S. economy is a gigantic house of cards that can collapse anytime. If you want to stick to safe investments in retirement like Certificate of Deposits and think the interest rates are going to be close to zero, you might want to convert your lump sum to annuities. While we tend not to recommend this at Personal Capital, if worry about the economy is truly keeping you up at night and impacting your life in a negative way, you could consider talking to your advisor about an annuity.
  • You think your life expectancy will be longer than average: If worrying about outliving your retirement savings is really an albatross around your neck and your family has a history of longer-than-average life spans, you might talk to an advisor about whether an annuity might work for you.

It’s important to reiterate that not all annuities are created equal and not all of them will fit your needs. If after all of this, you’re interested in exploring an annuity further, make sure that you talk to a fiduciary financial advisor and do all the calculations to figure out if it might make sense for your retirement goals.

Before You Buy an Annuity

As with ANY contract you sign or ANY financial product you buy, it’s always wise to ask questions and thoroughly understand what you’re buying. Yes, there are regulations in place to protect consumers up to a certain extent, but no one cares more about your money than you do. So before you buy an annuity make sure (1) you understand the annuity (2) you have done your research and believe you are a good candidate for the product (if you need assistance with this, talk to a fee-only financial advisor, don’t believe the advice from the insurance salesperson who is selling you the annuity) (3) you are buying a product that is suitable for your needs and matches your goals and (4) you are buying it from the best possible source, taking the fees and risks into consideration.

To do this, here are some questions to start with –

  1. How will an annuity help my retirement?
  2. How will this annuity reduce my risk?
  3. Is the annuity adjusted for inflation?
  4. What are guaranteed retirement income benefits?
  5. What is my risk tolerance? How will buying an annuity influence my risk tolerance versus investing my money in a mutual fund?
  6. How much money should I put into an annuity? What percentage of my assets should I have in an annuity?
  7. What is the rating and strength of the annuity issuer?
  8. What are the fees? What are the upfront purchase fees? How much will it cost me every year?
  9. How will I be taxed? Will I be taxed when I draw the money? Or when I pay into an annuity or both?
  10. How do I get my money out?
  11. What if I need to cash out my annuity; how much will I get? What are the surrender charges and penalties?  Does my contract have vesting?
  12. If my needs change, can I exchange this annuity for another one? How much will it cost? How much money will I lose in the transfer?
  13. Is there a free look period and how long is it?
  14. Is my annuity inflation adjusted?
  15. What is your commission for selling this product?

Our Take

If you are considering purchasing an annuity, make sure you are aware of the potential benefits and drawbacks, and how it fits into your overall retirement plan. Being fully informed is crucial, so it’s best to consult a trusted financial advisor to help you tease out the complex world of annuities.

Disclaimer: The information on this website is for informational purposes only and does not constitute a complete description of our investment services or performance. No part of this site nor the links contained therein is a solicitation or offer to sell securities or investment advisory services, except where applicable in states where we are registered, or where an exemption or exclusion from such registration exists. Third party data is obtained from sources believed to be reliable. However, Personal Capital Advisors Corporation cannot guarantee that data’s currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

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