An annuity is a financial product designed to pay a stream of income in the future. Insurance companies usually offer it to individuals eager to secure a steady cash flow after retirement.
How Does an Annuity Work?
When individuals purchase an annuity, their initial payment is referred to as the premium.
Insurance companies collect the premium in the form of a lump sum or through periodic payments.
During the accumulation phase, these institutions use the premium to invest in various vehicles, such as the stock market or bonds.
During the pay-out phase, the annuity begins to provide a stream of income that combines a portion of the premium with any investment gains.
The duration of these pay-outs can last for either a short period or for the remainder of the annuitant’s life.
Annuitants or policy owners receive income payments in one of two ways: through an immediate annuity or a deferred annuity.
In an immediate annuity, the annuitant starts receiving regular income relatively quickly.
After investing a lump sum, annuitants may start receiving pay-outs within a year from the policy’s start date, depending on their chosen frequency.
Immediate annuities are best suited for individuals nearing retirement and needing an instant and steady source of income.
In a deferred annuity, the policy owner begins to receive regular income or annuity at a specified time in the future, known as the maturity date, usually after the age of 59 ½.
This set-up is more suitable for younger individuals or those who do not need retirement income immediately.
Pay-outs may be higher in a deferred annuity because the premium can be invested for a longer time.
Despite the differences in the two options, they share one thing: the money invested in either will grow tax-free until the annuitant starts receiving payments.
Types of Annuities
There are several types of annuities that offer different advantages and disadvantages. These are:
Fixed annuities pay out a fixed amount. It also has a set interest rate that updates regularly after a predetermined number of years. The changes are made to adjust to the current rates in the market.
Compared to other investment types, the fixed annuity is more stable because it has limits on both gains and losses.
Indexed annuities fall somewhere in the middle in terms of risk and reward. They offer a guaranteed minimum payment. However, pay-out is also tied to the performance of an index, such as the Nasdaq Composite.
While the income payments in this type of annuity may fluctuate, it mainly protects you from losing any of your investments if the index declines.
Variable annuities offer the highest potential return of all three types.
However, this type also carries the greatest risk since it is based on the performance of the annuity’s underlying investment portfolio.
Payment amounts may be higher if the investment’s value increases. On the other hand, if the investments’ value dips, income payments may also be lower.
Cost of Annuities
It is essential to know the additional costs associated with an annuity before choosing to purchase one. Several of these fees are discussed below.
Some financial advisors get an annual commission for securing the sale of the annuity.
These commissions are typically not highlighted in the contract, and their total value will depend on the type of annuity.
Mortality and Expense Risk Charges
This charge protects the insurer from any losses that might occur if the policy owner unexpectedly dies. The fee is usually based on the annuitant’s age and amounts to an average of 1.25% of the account’s value each year.
This charge may also be used to pay a commission to the person who sold the annuity.
The issuer may charge you a flat annual fee or a percentage of your account value for administrative expenses, such as record-keeping.
Underlying Fund Expenses
The investment options chosen within the annuity will have their associated fees and expenses.
For example, if a fixed annuity is backed by bonds, the issuer may charge an annual fee to manage the underlying bond portfolio costs.
The annuitant may need to pay a 10% penalty to the Internal Revenue Service (IRS) if the money in the account is withdrawn before age 59 ½.
This early withdrawal refers to any amount withdrawn before the policy’s maturity date.
Aside from the penalty levied by the IRS, insurance companies may also charge for early withdrawals through surrender charges.
Depending on the investment’s values, the total penalty fees can be a significant sum, so it is crucial for policy owners to weigh their options before withdrawing funds from their annuity.
Fees for Extra Features
Fees for special features, such as long-term care insurance or guaranteed minimum income benefit, may be charged.
Understanding all the possible fees associated with an annuity is vital before getting one.
Pros of Getting Annuities
There are a few advantages to getting annuities, including:
Guaranteed Regular Income
Annuities can provide policy owners with a guaranteed stream of income for life. They can be used to supplement other sources of retirement income, such as a pension or Social Security.
However, individuals are encouraged to invest in insurance companies with high financial strength ratings from independent rating agencies.
This criterion increases the possibility that the insurer will consistently be able to pay-out the guaranteed income.
Contributions Grow Tax-Deferred
The amount contributed to an annuity grows tax-deferred, which means that taxes are only due once policy owners start receiving income from the annuity.
The tax break helps the invested premiums grow faster because taxes are not deducted from the earnings each year.
Annuity contracts can be customized to meet policy owners’ specific needs and goals.
For example, annuitants can choose a death benefit provision to ensure their loved ones will continue receiving the income after they die.
Other special benefits include long-term care insurance, which can be added to the annuity after paying extra fees.
Cons of Getting Annuities
There are also some disadvantages to getting annuities, including:
Expensive Annual Fees
Annuities can be expensive because of the annual fees charged by insurance companies. These fees include maintenance charges and charges for any special features added to the contract.
High Commission Rates
The commission rates on annuities are usually high, which can eat into its investment returns. Depending on the type of annuity, the commission could range from around 1% to 8%.
Subject to Penalty Fees
Annuities are subject to surrender charges if you withdraw your money before the start of the pay-out phase. For instance, if an annuitant has a 25-year annuity but withdraws the money after six years, they may be required to pay a surrender fee to their insurer.
An additional 10% penalty fee is also due to the IRS if the money is withdrawn before the age of 59 ½.
Are Annuities a Good Investment?
An annuity can be a good investment for people who want a consistent income stream during retirement.
It can also be the right option for those who have maxed out other retirement accounts and are looking for tax-deferred growth on their investments.
When extra charges are factored in, annuities can be expensive and may not be the best option for everyone.
The annuity also rests on the financial strength of the chosen insurance provider. Thus, it is crucial to select a company with good ratings.
Individuals may consult with a financial advisor to review different options before deciding to buy an annuity.
How to Buy an Annuity?
Once an individual decides to get an annuity, there are a few things they need to do to get started.
Step 1: Assess Financial Situation and Needs
The first step is for individuals to assess their financial situation and needs. They need to know how much income they will need during retirement and how long they expect to live.
Step 2: Choose from the Different Types of Annuities
Individuals must ensure that the type of annuity they choose aligns with their goals, risk tolerance, and age.
Step 3: Choose an Annuity Provider
Not all annuities are created equal. Individuals must compare different providers and choose those with strong financial ratings and good reputations.
They can compare companies based on fees, commissions, and over-all plan features.
Step 4: Apply for the Annuity
Once the individual has selected an annuity provider, they can begin processing their application. They need to provide all the required information and review their application carefully.
They must also choose how frequently they want to receive monthly, quarterly, or annual income payments.
Step 5: Pay the Required Premiums
The individual also needs to decide how they will pay for the required premium.
They can select between a one-time, lump-sum payment or a series of payments.
They must also choose how frequently they want to receive monthly, quarterly, or annual income payments.
Step 6: Start the Free Look Period
Once an individual has applied for the annuity and paid the required premiums, most insurance companies will give a free-look period. This is a period of time when the policy owner can review the annuity contract and decide whether they want to keep it or not.
If an individual decides that an annuity is not the right investment for them within this period, they get their money back without incurring a penalty.
However, if the individual decides to close their annuity after the free look period, they may be asked to pay the corresponding surrender charges.
The Bottom Line
An annuity is a contract between an individual and an insurance company.
The individual makes a lump sum payment or series of payments.
In exchange for these payments, the insurer agrees to provide the individual with regular income payments, starting immediately or in the future.
There are three types of annuities–fixed, variable, and indexed–which provide different benefits depending on an individual’s needs.
Annuities have a number of advantages, such as providing tax-deferred growth.
However, there are also some disadvantages to consider, such as high extra fees.
Whether or not an annuity is a good investment depends on an individual’s financial needs and goals.
An annuity may be a good option for those seeking a way to guarantee income during retirement. However, there are other options for those who prefer more flexibility.
If an individual decides to get an annuity, they must compare different providers before selecting one. They may also want to review the contract carefully and understand all the terms and conditions.
Finally, they can take advantage of the free look period. If the policy owner changes their mind about an annuity, they can cancel the contract during this period without paying any charges.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.