What Is an Annuity and How Does It Work?

An annuity is a contract with an insurance company where the buyer typically pays a lump sum premium to purchase the annuity, with the promise of a steady stream of income when they retire.

That said, annuity terms and conditions vary widely. In some cases, the individual might pay premiums over time in order to purchase the annuity. Some annuities make fixed payments; some are variable. Some annuities also offer an investment component.

Annuities come with a number of pros and cons. The upside is the potential for guaranteed lifetime income. The downside is that these contracts can be immensely complex, and often come with hidden fees and terms.

How Does an Annuity Work?

When purchasing an annuity, the account holder begins making premium payments, either over time or as a lump sum. The years of paying into an annuity are known as the accumulation phase. Sometimes, the payments can be made from an IRA or 401(k).

The money paid into the annuity account may be invested into the stock market or mutual funds, or it might earn a fixed interest rate over time.

Money paid into the annuity typically can’t be withdrawn for a certain amount of time, called the surrender period.

After the accumulation phase is over, the company begins making regular income payments to the annuity owner. This is known as the distribution phase, or amortization period, when the annuitant (the annuity holder) can withdraw funds from the annuity.

The annuitant can choose the length and start date of the distribution phase. For example, you might choose to receive payments for 10 years, or perhaps you prefer guaranteed payments for the rest of your life. Terms and fees depend on the structure of the distribution phase.

In many cases, withdrawals can only begin after the surrender period, and when the annuity holder is at least 59 ½. Before age 59 ½ the withdrawal would be considered an early withdrawal, and subject to a penalty (in addition to taxes).

Types of Annuities

The main annuity categories are fixed, variable, and indexed, but within those types there are various options and subcategories. The most important thing to remember about these contracts is that the terms and conditions vary widely; be sure to ask questions and fully understand what you’re buying.

Fixed Annuities

The principal paid into a fixed annuity earns a fixed amount of interest, usually around 5%. Although the interest is typically not as high as the returns one might get from investing in the stock market, this type of annuity provides predictable and guaranteed payments.

Variable Annuities

This type of annuity lets buyers invest in different types of securities, usually mutual funds that hold stocks and bonds. Although this can result in a higher payout if the securities do well, it also comes with the risk of losing money. Some variable annuities do come with a guarantee that investors will at least get back the money they put in.

Indexed Annuities

An indexed annuity is pegged to a particular index, such as the S&P 500 stock market index. How the index performs will determine how much the annuity pays out. Usually, indexed annuities cap earnings in order to ensure that investors don’t lose money.

For example, they might cap annual earnings at 6% even if the index performed better than that. But then in a bad year, they would pay out 0% earnings rather than taking a loss, and investors would still receive their base payment amount.

Immediate Annuities

With immediate annuities, investors begin receiving regular payments within a year of purchasing the annuity, depending on the terms of the surrender period. Immediate annuities can be expensive, but they offer retirees a way to plan for a more immediate income stream.

Deferred-Income Annuities

This type of annuity, also called a longevity annuity, is for people who are concerned they might outlive their retirement savings. Investors must wait until around age 80 to begin receiving payments, but they are guaranteed payments until they die.

The monthly payouts for deferred-income annuities can be higher than for immediate annuities, but risk is involved. If the investor dies before starting to receive payments, heirs may not receive the money in the annuity account.

Married couples might opt for a joint-life version, which has lower monthly payouts but continues payments for as long as either spouse lives.

Equity-Indexed Annuities

Equity-indexed annuities offer a combination income strategy. Investors receive a fixed minimum amount of income, in addition to a variable amount that’s pegged to a market index. These products provide some guaranteed income, and thus a certain protection against downside risk, but can be expensive.

Fixed-Period Annuities

Fixed period annuities allow buyers to receive payments for a specific number of years.

Retirement Annuities

With retirement annuities, investors pay into the account while still working. Once they retire, they begin receiving payments.

Direct-Sold Annuities

These annuities have no sales commission or surrender charge, making them less expensive than other types of annuities.

Pros of Annuities

There are several reasons people choose to pay into annuities as part of their retirement plan. The upsides of annuities include:

•   Guaranteed and predictable payments: Depending on the annuity, a guaranteed minimum income benefit (GMIB) can be set for a specific number of years or for the buyer’s lifetime. Payments may even be made to a buyer’s spouse or other beneficiary in case of death.

•   Tax-deferred growth: Interest earned on annuity deposits is not taxed immediately. Annuity owners generally don’t pay taxes on their principal investment; they pay income taxes on the earnings portion in the year they receive payments, similar to withdrawals from a 401(k) or IRA.

•   Low involvement: Once the annuity is purchased, the annuity company uses an annuity formula to figure out how much each payment should be and to keep track of account balances. All the investor has to do is pay into the account during the accumulation phase.

•   No investment limits or required minimum distributions: Unlike an IRA or 401(k), there is no limit to the amount of money that can be invested into an annuity. Further, there is no specific age at which investors must begin taking payments (i.e., no required minimum distributions).

•   Option to bolster other retirement savings: For those closer to retirement, an annuity may be a good option if they’ve maxed out their other retirement savings options and are concerned about having enough money for living expenses.

Cons of Annuities

Like any type of investment, annuities come with downsides:

•   Lower potential returns: The interest earned by annuities is generally lower compared to what investors would earn in the stock market or bonds.

•   Penalty for early withdrawals: Once money is invested in an annuity, there can be restrictions on withdrawals. For example, an early withdrawal before age 59 ½ might incur taxes/penalties. Be sure to understand the withdrawal terms of the annuity you own, as well as state regulations.

•   Fees: Annuities can have fees of 3% or more each year. There may also be administrative fees, and fees if the investor wants to change the terms of the contract. It’s important before buying an annuity to know the fees included and to compare the costs with other types of retirement accounts.

•   Death benefit terms: If investors die before they start receiving payments, they miss out on that income. Some annuities include a death benefit (where money invested in the annuity is passed to a beneficiary), but others do not. There may be a fee for passing the money on.

•   Potential to lose savings in certain circumstances: If the insurance company that sold the annuity goes out of business, the investor will most likely lose their savings. It’s important for investors to research the issuer and make sure it is credible.

•   You pay for inflation adjustments: Annuity payments usually don’t account for inflation, but it’s possible to pay for an inflation adjustment for your payouts.

•   Risk: Variable annuities in particular are risky. Buyers could lose a significant amount, or even all of the money they put into them.

•   Complexity: With so many choices, buying annuities can be confusing. The contracts can be dozens of pages long, requiring close scrutiny before purchasing.

What Are Annuity Riders?

When investors buy an annuity, there are extra benefits, called riders, that they can purchase for an additional fee. Optional riders include:

•   Lifetime income rider: With this rider, buyers are guaranteed to keep getting monthly payments even if their annuity account balance runs out. Some choose to buy this rider with variable annuities because there’s a chance that investments won’t grow a significant amount and they’ll run out of money before they die.

•   COLA rider: As mentioned above, annuities don’t usually account for inflation and increased costs of living. With this rider, payouts start lower and then increase over time to keep up with rising costs.

•   Impaired risk rider: Annuity owners receive higher payments if they become seriously ill, since the illness may shorten their lifespan.

•   Death benefit rider: An annuity owner’s heirs receive any remaining money from the account after the owner’s death.

How to Buy Annuities

Annuities can be purchased from insurance companies, banks, brokerage firms, and mutual fund companies. As mentioned, it’s important to look into the seller’s history and credibility, as annuities are a long-term contract.

The buyer can find all information about the annuity, terms, and fees in the annuity contract. If there are investment options, they will be explained in a mutual fund prospectus.

Some of the fees to be aware of when investing in annuities include:

•   Rider fees: If you choose to buy one of the benefits listed above, there will be extra fees.

•   Administrative fees: There may be one-time or ongoing fees associated with an annuity account. The fees may be automatically deducted from the account, so contract holders don’t notice them, but it’s important to know what they are before sealing the deal.

•   Surrender charges: An annuity owner who wants to withdraw money from an account before the date specified in the contract will face a surrender charge.

•   Penalties: Owners who want to withdraw money before age 59 ½ will be charged a 10% penalty by the IRS (in addition to the usual income tax due on the income from the annuity).

•   Mortality and expense risk charge: Generally annuity account holders are charged about 1.25% per year for the risk that the insurance company is taking on by agreeing to the annuity contract.

•   Fund expenses: If there are additional fees associated with mutual fund investments, annuity owners will have to pay these as well.

•   Commissions: Insurance agents are paid a commission when they sell an annuity. Commissions may be up to 10%.

The Takeaway

No matter what stage of life you’re in, it’s not too early or too late to build an investment portfolio. Younger investors may not be ready to buy into an annuity, but they can still start saving for retirement. For those who are considering an annuity as a retirement investment, it’s important to weigh both the pros and cons — as well as the opportunity cost of putting money into an annuity versus other investments.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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