How do annuities work?

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In a Nutshell

Annuities are essentially insurance contracts. You pay a set amount of money today, or over time, in exchange for a lump-sum payment or stream of income in the future. The type of annuity and the details of the particular annuity can determine the payouts you’ll receive.

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If you’re considering an annuity to provide a steady stream of income in retirement, here are some key things to know about how annuities work.

An annuity can be a very confusing thing. While the basic concept of an annuity is simple, the details of how they work are often complicated. Thankfully, we’re here to share the basics of how annuities work so that you can understand them better.

In general, annuities are an insurance product that can provide you a future lump-sum payment or income stream. Basically, you buy an annuity with a single upfront payment, or by making a series of payments to the insurance company. Then, the insurance company sends you either one lump sum or multiple payments during retirement.

The amount of the future payments is largely based on the type of annuity you choose, the amount you pay for the annuity and other factors. So how do annuities work? Here are some key things you should know.


Types of annuities

While each type of annuity can have variations, there are generally three main types of annuities to choose from. If you’re considering an annuity, make sure you understand the different types and their associated fees before choosing. Sometimes riders are available that can be attached to your annuity contract to give you extra options. Keep in mind that you’ll probably have to pay more for a rider.

Fixed annuities

A fixed annuity is fairly straightforward. With it, the insurance company promises you a set rate of interest that is locked in rather than being tied to market rates.

Here are two types of fixed annuities.

  • Immediate fixed-income annuities usually require you to pay a lump sum to receive a guaranteed stream of income for a set period of time, which could extend for life, depending on what your contract states. Payments typically start immediately.
  • Deferred income annuities are similar to immediate fixed-income annuities. The major difference is that the income stream is deferred. Instead of beginning immediately, your income stream can start anywhere from months to years from when you buy your annuity — this is commonly known as the accumulation period, because your annuity is accumulating interest. You may be able to make extra payments during the deferral period to increase your future income.

Variable annuities

Variable annuities aren’t as straightforward as fixed annuities. They’re more of an investment product. And you’ll have to decide which investment options you want to direct your annuity payments to.

The amount of your future income stream will be based on the amount of your payments and the return of the investments you choose within your annuity, as well as any fees or other expenses the annuity charges. While a variable annuity may give you a chance for better returns and a higher payout, it could just as well result in a lower-than-anticipated income in retirement.

Indexed annuities

Indexed annuities are somewhat of a mix between a fixed and variable annuity. Essentially, indexed annuities can offer protection from drops in the market, but you also won’t benefit as much if the market does well.

With an indexed annuity, you can get a base amount of guaranteed income. But another part of your income stream will depend on the performance of an index, like the S&P 500, which gives you the chance for investment growth.

FAST FACTS

Who regulates the annuities you buy?

Who regulates annuities can depend on the type of annuity you buy. State insurance commissioners regulate both fixed annuities and indexed annuities. You can make sure your insurance broker is registered to sell annuities in your state before you make your purchase by checking with your state insurance commission. The Securities and Exchange Commission regulates variable annuities. You can use BrokerCheck to see if your broker or adviser is registered. 

Reasons to consider an annuity

Buying an annuity can provide a bit of peace of mind when it comes to your income in retirement. An annuity can provide you with a stream of income in retirement that you can rely on in addition to any pensions or Social Security benefits you might receive.

If you choose an annuity that provides payments for the remainder of your life, you might not have to worry about running out of money in retirement, as long as the annuity can cover your expenses. These guarantees can add some certainty to how much money you need to save to retire comfortably.

Annuities can be complicated though, and they may not be for everyone or for every situation, so it’s best to consider reasons you may not want to get an annuity.

Reasons to skip getting an annuity

An annuity isn’t the answer for everyone. First, your annuity payments depend on the insurance company’s ability to make your annuity payments. If the insurance company you bought your annuity through goes under, you may no longer receive the income you’d counted on, which might leave you in an awful financial position come retirement time. But individual states have a life and health insurance guaranty association that could help you get some relief if the insurer goes under.

And while annuities may sound like an easy solution to providing income in retirement, that income can cost. Annuities come with a variety of fees that can add up quickly, which can include surrender charges, insurance charges, investment-management fees, rider fees and contract fees just to name a few.

On top of the fee issue, an annuity may not provide the same returns you might be able to achieve investing elsewhere. You’re giving up some of the potential upside you might otherwise earn for the security of having that future income.

This could leave you with a smaller income in retirement than you could have generated by investing elsewhere, like in an a retirement account.

Learn more: Annuities: Pros and cons

Bottom line

Now that you can better answer the question “How do annuities work?” With this knowledge, the decision about whether to get an annuity is up to you, and potentially a financial adviser. You’ll need to factor in your specific situation, preferences and risk tolerance to decide if an annuity (and what kind of annuity) could be worth it for you.

If you do decide to get an annuity, make sure you understand the annuity you buy beforehand. This includes understanding the fine print and asking for help from a qualified professional if you need it. Finally, don’t forget to shop around to find an annuity that fits your situation, as contracts can vary greatly from company to company.


About the author: Lance Cothern is a freelance writer specializing in personal finance. His work has appeared on Business Insider, USA Today.com and his website, Mone… Read more.