An annuity is a financial contract issued and distributed by an insurance company. Individuals purchase annuities with the expectation of receiving a fixed or variable income stream. This income stream can begin immediately or at a future date in exchange for premiums paid. Unlike a life insurance policy, which pays out upon the insured’s death, an annuity is designed to provide income to the purchaser, known as the annuitant, typically during retirement.
People invest in annuities by making either monthly premium payments or a single lump-sum payment. The financial institution then provides a stream of payments for a specified period or for the remainder of the annuitant’s life. Annuities are primarily used to secure retirement income, helping individuals mitigate the risk of outliving their savings.
Key Takeaways
- Annuities are financial instruments that provide a guaranteed income stream, commonly used by retirees.
- The accumulation phase involves funding the annuity with a lump sum or regular payments.
- The annuitization phase starts when the annuitant receives payments for a defined period or for life.
- Annuities offer flexibility through various structuring options.
- Annuities are categorized as immediate or deferred, and as fixed, variable, or indexed.
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How an Annuity Works
Purpose
Annuities are structured to provide a consistent cash flow during retirement, addressing the concern of outliving one’s assets. If existing assets are insufficient to maintain a desired standard of living, purchasing an annuity contract from an insurance company or other financial institution can be a strategic solution.
Annuities are well-suited for individuals seeking stable, guaranteed retirement income. However, invested funds are typically illiquid and subject to withdrawal penalties. Therefore, annuities may not be the best choice for younger individuals or those with short-term liquidity needs.
Phases
Annuities involve different phases: the accumulation phase (where contributions are made) and the annuitization phase (where payments are received).
Immediate vs. Deferred
Annuities can be classified as immediate or deferred.
Immediate annuities are often purchased by individuals who have received a substantial lump sum, such as from a settlement or lottery win. They opt to convert this sum into a stream of future cash flows. Deferred annuities, on the other hand, are designed to grow on a tax-deferred basis. They provide guaranteed income starting at a specified future date chosen by the annuitant. The key difference lies in when the income stream begins.
Regulation
Variable annuities are regulated by the Securities and Exchange Commission (SEC) and state insurance commissioners. Fixed annuities, not being securities, are regulated by state insurance commissioners only. Indexed annuities typically fall under the purview of state insurance commissioners. However, if registered as securities, they are also regulated by the SEC.
The Financial Industry Regulatory Authority (FINRA) also oversees variable and registered indexed annuities.
Agents or brokers who sell annuities are required to hold a state-issued life insurance license. For variable annuities, a securities license is also necessary. These professionals generally earn a commission based on the annuity contract’s notional value.
Important Considerations
Annuities can have complex tax implications. Before purchasing an annuity contract, it is crucial to fully understand how they work and to consult with a qualified financial advisor.
Other Considerations
Surrender Period and Withdrawals
Annuities typically have a surrender period during which withdrawals are subject to surrender charges or fees. This period can last for several years.
Investors should assess their financial needs during the surrender period to ensure they can afford to make the required annuity payments, especially if significant expenses are anticipated.
Many insurance companies permit annuitants to withdraw up to 10% of their account value annually without incurring a surrender fee. However, exceeding this limit, even after the surrender period has ended, may result in penalties. Withdrawals made before age 59½ may also trigger tax implications.
In some cases, annuitants facing financial hardship may choose to sell their annuity payments due to the potentially high cost of withdrawals. This is analogous to borrowing against any income stream, where the annuitant receives a lump sum in exchange for relinquishing rights to future annuity payments.
Income Riders
Annuity contracts may include income riders that guarantee a fixed income once the annuity begins paying out. When considering income riders, investors should ask:
- At what age will the income be needed? Payment terms and interest rates can vary based on the annuity’s duration.
- What fees are associated with the income rider? While some organizations offer them without charge, most impose fees for this service.
By investing in annuities, individuals can protect themselves against longevity risk, ensuring they will not outlive their income stream. However, it is crucial to understand that purchasing an annuity involves exchanging a liquid lump sum for a guaranteed series of cash flows.
It’s important to note that the primary purpose of an annuity is not to generate a profit through future cash-outs.
Fast Fact
Defined benefit pensions and Social Security are both examples of lifetime guaranteed annuities that provide retirees with a steady cash flow until their death.
Annuities in Workplace Retirement Plans
Annuities can be a valuable addition to a retirement plan. However, due to their complexity, many employers do not include them as part of an employee’s retirement portfolio.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act, enacted in 2019, has relaxed certain rules, granting employers greater flexibility in selecting annuity providers. This legislation allows for the inclusion of annuity options within 401(k) or 403(b) investment plans, potentially leading to increased annuity investments by qualified employees.
Types of Annuities
Annuities can be structured in various ways based on factors such as the duration of guaranteed payments.
They can be designed to continue payments as long as either the annuitant or their spouse is alive if a survivorship benefit is chosen. Alternatively, annuities can be structured to pay out funds for a fixed period, such as 20 years, regardless of the annuitant’s lifespan.
Immediate and Deferred Annuities
Annuities can begin making payments immediately upon depositing a lump sum (immediate annuities) or be structured for deferred benefits.
Immediate payment annuities start paying out as soon as the annuitant deposits a lump sum. Deferred income annuities, on the other hand, do not begin payments immediately. Instead, the client specifies an age at which they want to start receiving payments.
Depending on the type of annuity, the principal invested may or may not be recoverable. In a straight, lifetime payout, there is no refund of the principal; payments simply continue until the annuitant’s death.
If the annuity is set for a fixed period, the recipient or their heirs may be entitled to a refund of any remaining principal.
Fixed, Variable, and Indexed Annuities
Annuities are commonly structured as fixed, variable, or indexed:
Variable annuities involve market risk and the potential for principal loss. However, riders and features can be added, typically at an additional cost, to create hybrid fixed-variable annuities. These allow contract owners to benefit from potential portfolio upside while also having the protection of a guaranteed lifetime minimum withdrawal benefit in case the portfolio’s value declines.
Other riders can be purchased to add a death benefit to the agreement or to accelerate payouts if the annuity holder is diagnosed with a terminal illness. A cost-of-living rider will adjust the annual base cash flows for inflation, tracking changes in the consumer price index (CPI).
Criticism of Annuities
One major criticism of annuities is their illiquidity. Funds deposited into annuity contracts are typically locked up for a surrender period, which can range from two to more than 10 years, depending on the product. Withdrawing funds during this period incurs a penalty.
Surrender fees can start at 10% or higher and generally decrease annually over the surrender period.
Another criticism is that annuities can be complex and costly. Individuals may purchase an annuity without fully understanding how it works or the associated costs. Thorough research is essential to ensure a clear understanding of all fees, charges, expenses, and potential penalties.
Fast Fact
The Retirement Security Rule, issued by the U.S. Department of Labor in 2024, mandates that investment professionals advising on retirement accounts act as fiduciaries and provide advice that is in the best interest of retirement investors. The rule was set to take effect in September 2024 but is currently subject to litigation as the insurance industry challenges protections that are anticipated to significantly limit commissions on annuities.
Annuities vs. Life Insurance
Life Insurance
Life insurance companies and investment companies are the primary providers of annuity products.
Annuities provide a natural hedge for life insurance companies. Life insurance addresses mortality risk, the risk of premature death. Policyholders pay premiums to the insurance company, which pays out a lump sum upon their death.
If a policyholder dies prematurely, the insurer pays the death benefit at a net loss. Actuarial science and claims experience enable insurance companies to price policies to ensure that, on average, policyholders live long enough for the insurer to profit.
The cash value within permanent life insurance policies can be exchanged for an annuity product via a 1035 exchange, often without tax implications.
Annuities
Annuities address longevity risk, the risk of outliving one’s assets. The risk to the annuity issuer is that holders will survive beyond their initial investment. Annuity issuers may mitigate this risk by selling annuities to customers with a higher risk of premature death.
Examples of an Annuity
- A life insurance policy is an example of a fixed annuity where an individual pays a fixed amount monthly for a predetermined period, typically until age 59½, and receives a fixed income stream during retirement.
- An individual makes a single premium payment, such as $200,000, into an immediate annuity. They then immediately receive regular payments, such as $5,000 a month, for a fixed time. The payout amount for immediate annuities is subject to market conditions and interest rates.
Who Buys Annuities?
Annuities are suitable for individuals seeking stable, guaranteed retirement income. Due to the illiquidity and potential withdrawal penalties, they are not recommended for younger individuals or those with immediate liquidity needs. Annuities protect against longevity risk, ensuring that the annuitant will not outlive their income.
What Is a Non-Qualified Annuity?
Annuities can be purchased with pre-tax or after-tax dollars. A non-qualified annuity is purchased with after-tax dollars, while a qualified annuity is purchased with pre-tax dollars (e.g., through 401(k) or 403(b) plans). In a non-qualified annuity, only the earnings, not the contributions, are taxed at withdrawal, as the contributions were made with after-tax money.
What Is an Annuity Fund?
An annuity fund is an investment portfolio where an annuity holder’s payments are invested. This portfolio can include stocks, bonds, and other securities. The returns earned by the annuity fund influence the payout received by the annuity holder.
What Is the Surrender Period?
The surrender period is the time during which an investor must wait before withdrawing funds from an annuity without incurring a penalty. Withdrawals made before the end of this period may result in a surrender charge, which functions as a deferred sales fee. The surrender period typically lasts for several years.
The Bottom Line
An annuity represents a financial contract between a purchaser and an insurance company. The purchaser makes either a lump sum payment or regular payments over time. In return, the insurance company provides regular payments to the annuity owner, either immediately or at a designated future point. Annuities can be fixed, variable, or indexed to an equity index like the S&P 500.
