What Are Annuities, and How Do They Work?

While building your investment portfolio or planning for retirement, you may have wondered, what are annuities? Annuities are a type of tax-deferred investment that guarantee a rate of return or an amount of income.

Created primarily for use in retirement, an annuity is a contract between a consumer and an insurance company that provides a guaranteed income stream to supplement Social Security, pensions and other retirement savings accounts.

How do annuities work?

Annuities are regulated by the Securities and Exchange Commission, or SEC, and the Financial Industry Regulatory Authority, or FINRA. Consumers can purchase annuities either with a lump-sum payment or through monthly premiums. The investment grows through an accumulation phase, which varies based on the terms of the contract. During the annuitization or distribution phase, the insurance company sends set payments over a certain amount of time or for the remainder of the investor's life.

Annuities are popular because they can create a source of income that an investor can't outlive and the market can't disrupt since the insurance company assumes the risk. To offset their risk, insurance companies charge fees for management and administrative services. Most annuities also include a surrender period where an investor isn't allowed to withdraw money from the annuity without incurring a surrender charge.

What types of annuities are there?

Immediate and deferred annuities

Different types of annuities provide flexibility for investors. For example, annuities can be classified as either immediate or deferred. An immediate annuity is purchased with a one-time lump-sum contribution that can be distributed with regular income payments within a year after purchasing the contract. Lottery payments are an example of an immediate annuity.

On the other hand, deferred annuities are purchased either through a lump-sum contribution or with monthly premiums. Investors specify the date at which they would like to begin receiving payments, typically 10 to 30 years in the future, coinciding with retirement age.

Fixed and variable annuities

Annuities can also be classified as fixed or variable. Fixed annuities provide regular payments to the investor based on the minimum interest rate guaranteed at the time of purchase. This type of annuity is similar to a certificate of deposit, or CD. However, a variable annuity can be placed in stocks, bonds or mutual funds, with fluctuating returns based on the performance of the investments. Variable annuities carry some market risk, but they also provide a guaranteed lifetime minimum withdrawal benefit if the portfolio loses value.

How are annuities different from life insurance?

Annuities and life insurance are both long-term investments that can be integral parts of planning for retirement. You may decide that both have an important role in your financial plan as they serve two different purposes.

Simply put, an annuity is an insurance policy that pays out during retirement, and life insurance is a policy that pays out after your death. Life insurance addresses your mortality risk—the risk of dying prematurely and leaving your loved ones in a challenging financial situation. Annuities address your longevity risk—the risk of outliving your assets.

If you're looking for a steady stream of income during retirement, this is the benefit an annuity will provide. If you're looking to provide financial assistance for your loved ones after you die, this is what life insurance is designed to accomplish. Nevertheless, some annuities may include a death benefit that will pay your heirs a certain minimum when you die.

What are the pros and cons of annuities?

Pros

Like any financial or insurance product, annuities have pros and cons to consider. The main benefit is that they create a predictable income stream to supplement other retirement funds. A fixed annuity offers locked-in gains, which are usually higher than fixed interest rates for a CD. Furthermore, you'll have less worry about outliving your savings or weathering a volatile stock market that can impact your balance and ability to make withdrawals.

Another plus to this form of investment is the ability to save money for retirement with tax-deferred growth. As with individual retirement accounts (IRAs) and 401(k)s, investors who purchase deferred annuities won't pay taxes on the gains until after a withdrawal. And unlike 401(k)s and IRAs, annuities also have no contribution limits, which can be beneficial to high-net-worth individuals who are limited in the amount they can save before taxes.

Because annuities are insurance contracts, the investor also reduces their potential risk. Stocks, bonds and mutual funds all have the potential to drop in value based on market conditions, impacting your IRA and 401(k). With an annuity, however, the investor is buying a guarantee from the insurance company of a certain rate of return. This provides peace of mind in retirement.

Cons

When it comes to disadvantages, annuities come with an opportunity cost. Young investors or people with a high risk tolerance may benefit from more aggressive investments that can generate higher returns, especially if they have extended time before retirement. With annuities, you don't have control over how the money is invested, which can limit your gains.

Annuities also offer limited liquidity, depending on your contract. For example, you may only have access to a small percentage of the contract value each year until it expires. If you don't have other liquid accounts, you could inadvertently lock up your money or be subject to surrender fees for early withdrawals.

If you purchase an immediate annuity, you can only defer taxes on investment gains for the first few years. And unlike CDs or money market accounts, annuities aren't insured by the FDIC. However, they are backed by the insurance company's State Guaranty Association in case of insolvency.

Are annuities right for you?

While annuities can be complex, they can also be an essential part of your retirement planning process. It's important to understand what annuities are and how they work before you invest your money. To choose the best option for you, reach out to a financial advisor who can help you make the right choice for your future.