Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
Pensions used to be a common feature of company benefit plans. After a long career, retirees would enjoy a steady paycheck month after month as a reward for their work.
Annuities are a more modern approach to the same end result. They are an investment product that offers the security of guaranteed income in your retirement years.
We will cover the basics of annuities and discuss whether they are right for you.
What is an annuity and how does it work?
Annuities are a type of insurance contract designed to protect your income in retirement. You make a payment or series of payments while you’re working and earning income. In exchange, you can receive monthly payments during your retirement.
The amount you receive back will typically be your initial investment, plus interest.
There are many different types of annuities. The differences are typically defined in how you buy them, how you fund them over time and how they are paid out. The main types, which we’ll touch on shortly, are:
- Fixed annuity
- Variable annuity
- Indexed annuity
These investments often have the advantage of being tax-deferred, meaning that you do not need to pay taxes on the money that goes into them. Instead, you pay taxes when you receive the income, when your tax bracket tends to be lower. They also do not have limits on how much you can invest, unlike other retirement products.
However, they are not a liquid investment. You will often pay a penalty to access your money before retirement.
Annuities also have higher costs than individual retirement accounts (IRAs) and 401(k) accounts, so most financial advisors recommend investing in annuities only after maxing out the others. You will be responsible for several different fees depending on the type of annuity.
The process of investing in annuities has two phases: accumulation and distribution.
Annuity accumulation phase
The accumulation phase refers to the period of time in which you are saving money for retirement. You may choose to make regular payments into your annuity account, and you can select the investments in which you want your money stored.
Annuity distribution phase
In the distribution phase, you start to get your money back. This is when all the money you’ve saved over the years begins to be paid out. This typically is done via monthly payments from the insurance company (though a lump sum payout is an option), and is paid for a set period of years or for the remainder of your life. The amount you receive in the distribution phase is typically your principal plus interest — minus fees.
Types of annuities
There are three common types of annuities: fixed, variable and indexed. Each category has its advantages and drawbacks. The type you choose will generally depend on how close you are to retirement and your risk tolerance.
Within these three categories, annuities can be deferred or immediate. This refers to when you start receiving payments.
|Fixed Annuity||Variable Annuity||Indexed Annuity|
|Funding options||Lump sum||Buying in over time, with a minimum initial investment||Buying in over time, with a minimum initial investment|
|Payout options||Monthly payments or lump sum||Monthly payments or lump sum||Monthly payments or lump sum|
|Rate of return||Interest paid at a fixed rate on initial investment||Based on the performance of investments you choose||Fixed interest rate, or rate tied to an index such as the S&P 500|
Contract fee: Set dollar amount paid once or annually
Surrender fee: If you need access to your money during the accumulation period, you will typically pay a surrender or withdrawal charge
Transaction fee: This is charged per premium payment
Insurance fee: This is typically paid as a percent of assets and covers the insurance company’s guarantees, such as lifetime payments
Surrender charge: This is a fee for an early withdrawal
Investment fee: This pays for the management of underlying assets in the annuity, such as stocks and bonds
May also have a fee for optional benefits, such as the guarantee of a minimum payout
Participation rate: You will not get credited for the full performance of the index; instead, you get a certain percentage, with the rest retained by the insurance company
Rate cap: Many indexed annuities will have a maximum return you can receive; if the index exceeds that rate, the rest is retained
Margin or administrative fee: This is generally a retained percentage of the index’s gain
|Liquidity||Not very liquid; while investors can access their money, this will typically involve a penalty||Not very liquid; while investors can access their money, this will typically involve a penalty||Not very liquid; while investors can access their money, this will typically involve a penalty|
|Regulation||By state insurance commissioners||By state insurance commissioners||By state insurance commissioners|
|Taxation||Tax-deferred earnings; withdrawals of earnings taxed as ordinary income||Tax-deferred earnings; withdrawals of earnings taxed as ordinary income||Tax-deferred earnings; withdrawals of earnings taxed as ordinary income|
With a fixed annuity, you pay a lump sum to an insurance company in exchange for a series of monthly payments. These payments can last for a set period — say, 10 or 20 years — or for the remainder of the buyer’s life. The amount received typically does not change for the duration. Some fixed annuities offer a cost-of-living adjustment, in which the amount you receive rises slightly over time to account for inflation. (More on this later, too.)
An advantage of fixed annuities is the certainty they provide. You will never outlive your investment, and you can count on a certain amount of income each month.
However, the upfront cost can be steep and there is typically not a way to terminate the contract for a refund. There is also a chance that you will not recoup the amount you paid before you die.
A variable annuity is essentially a type of retirement investment account. The buyer makes regular payments into the annuity, choosing the type of investments they want. This is much like a 401(k) in that you can have your money in stocks and bonds to grow over time.
At retirement age, the sum saved can be converted into a penalty-free stream of monthly payments for the remainder of the person’s life.
Variable annuities can be a good option for somebody early in their career with ample time to save for retirement. These investors often have the ability to weather market fluctuations and enjoy long-term gains in the market while being able to ride out dips.
An indexed annuity is similar to a variable annuity in that you can invest in one over time, and the amount you receive back can vary. However, there are some key differences.
With variable annuities, your money is invested in the market. Indexed annuities are not, so the money you put in — your principal — is protected.
However, there is still the opportunity for your money to grow over time. The insurance company typically offers two options for return. The first is a fixed interest rate. The other is a rate of return that is tied to an external index, such as the S&P 500. If the S&P 500 goes up, you receive that rate of return. If the S&P 500 goes down, you receive no additional money but your principal is not lost.
Deferred annuity vs. immediate annuity
The terms “deferred” and “immediate” typically refer to when the buyer begins receiving payments.
Immediate annuities tend to be fixed, and the buyer begins receiving payments immediately. Deferred annuities begin paying out at some point in the future, like when the buyer hits retirement, allowing the investment to earn interest in the meantime.
Deferred annuities can generally begin as soon 13 months after purchase, but you can sometimes wait up to 40 years.
Annuity costs and fees
Annuities can be an expensive way to save. The industry average for annual annuity fees is 2.24%. However, the specific fees you’ll pay can vary by company and product.
|Average Annuity Fees|
|Fee type||Average cost|
|Base annuity fee||1.31%|
|Investment advisory fee||0.54%|
|Guaranteed lifetime withdrawal benefit fee||0.25%-2.25%|
Base annuity fees: These may have slightly different names — like mortality and expense fees or insurance charges — but they typically cover administrative costs and the risk the insurance company takes on to guarantee payments for the entirety of a customer’s life.
Investment advisory fees: Incurred most often in variable annuities, where the insurance company will park the customer’s money in certain investments, such as stocks or bonds.
Surrender charges: Incurred when you need to access your money during the accumulation phase. These often vary based on how long you have held the annuity. For example, one annuity analyzed by Morningstar charges a 7% fee to cancel if the annuity has been held for less than two years. Between two to four years, the fee drops to 6% — with further drops after subsequent years until it reached zero at seven years. Some annuities advertise that they do not charge a surrender fee.
Guaranteed lifetime withdrawal benefit fees: Also known as a rider, this is a way to limit the downside on a variable annuity. You pay a little extra to set a floor for the amount of money you will receive back.
Cost-of-living adjustments for annuities
A cost-of-living adjustment is meant to protect against rising costs due to inflation or other factors over time. In many annuities, you can choose an option that automatically increases the amount you receive in the distribution phase by a certain amount. This might be a set percentage — from 1% to 5% — or a rate tied to the Consumer Price Index.
How annuities are insured and regulated
Annuities are not deposit products and therefore are not insured by the Federal Deposit Insurance Corp. (FDIC). They are investment products. And in many cases, you can lose the principal you put into them.
Annuities are often insured to some degree by state guaranty associations, but the rules and coverage varies. For example, the North Carolina Life & Health Insurance Guaranty Association protects a maximum of $300,000 for most people. The Life Insurance Co. Guaranty Corp. of New York covers $500,000 per person, while the organizations in California and Texas cover just $250,000.
There are, however, numerous regulations for how annuities are taxed. In most cases, your tax liability on gains in an annuity are deferred until you withdraw them. In exchange, though, you generally must pay a 10% IRS penalty if you withdraw from your annuity before age 59 ½.
There are limits on how much money you can invest in annuities with pre-tax money, which is set at $19,000 in 2019 for most savers. There are no limits on using after-tax money to buy annuities.
Should you invest in annuities?
Annuities are a complex financial instrument—and the decision to buy one should be made thoughtfully. With that complexity comes higher costs.
Because of this, some companies market annuities heavily, said Ken Tumin, founder and editor of DepositAccounts, a LendingTree subsidiary.
"They make salespeople a lot of money,” Tumin said.
However, they can be a good option for a retirement saver who has maxed out the amount they can save in an IRA or corporate 401(k). They can also be useful as a form of “longevity insurance,” Tumin said. If you are concerned about outliving your retirement savings, an annuity can be a great option.
Be sure to shop around for an annuity with the lowest fees. You can sometimes find an annuity without a surrender charge, and shoppers should look carefully at the base fees in each product.
Annuities are a complex concept with a simple goal — making sure you have a steady income in retirement. Before investing, make sure you thoroughly understand the amount you are paying and the benefits you are receiving in return.