Annuity
What Is An Annuity?
An annuity is a product that can provide you with a lifetime income, typically in retirement. Annuities are viewed as a way to hedge against longevity risk, or the potential for one to outlive one’s invested assets.
Social Security and many defined-benefit pension payments are often described as ‘annuity-like’ income streams because they can provide regular lifetime payments.
Annuities can be structured with a variety of different specifications. Because annuities are designed to provide a stream of payments, they’re commonly structured to pay for the annuitant’s lifetime or for a defined period, and some options can continue payments to a spouse or other beneficiary depending on the contract.
They can also be constructed as providing benefits over a set period of time, such as 25 years. Annuity payouts can also begin at the outset of a lump sum deposit, or can take place at a certain specified point in the future, such as ten years from initial deposit or when the annuitant comes of retirement age.
The payment sum, typically monthly, can also be set up as a fixed or variable structure.
A fixed rate provides the safety of a known monthly number. But it also sets up risk in the form of higher inflation, reducing its real value or leaving cash on the table in the event the investments perform better than expected.
A variable structure allows for payments to ebb and flow based on returns and can also provide less risk for the issuer (usually a life insurance company) of the product by avoiding getting locked into a fixed payout scheme.
The Accumulation Phase
The accumulation phase is the period when you’re funding the annuity (either with a lump sum, a series of payments, or both, depending on the contract).
How the value grows depends on the annuity type: it may be based on a declared interest rate (fixed), an index-based crediting formula (fixed indexed), or the performance of investment options (variable).
The Distribution Phase (or the annuitization phase)
The distribution phase begins when the annuitant starts to receive payments from the annuity.
The frequency and amount of payments are determined by the terms of the contract.
Who Are Annuities Good For?
Invested cash in annuities is illiquid and often subject to surrender charges if withdrawn early, so they are not generally good for those with regular or uncertain liquidity needs.
They are good for retirees who want reassurance that they’ll continue to receive a stream of income for the duration of their lives to ensure that they don’t outlive their assets.
Types Of Annuities
There are two broad timing categories of annuities:
- Immediate (income starts soon after purchase) and
- Deferred (income starts later, after an accumulation period).
Within those timing categories, annuities are also commonly described by how they credit returns or take risk, such as fixed, fixed indexed, or variable.
Immediate Annuities
Immediate annuities begin paying out immediately after the initial deposit is made, while deferred annuities allow for a period of accumulation before payouts begin.
With an immediate annuity, you make a lump sum payment and then start receiving payments immediately. This is ideal for someone who wants to start making an income immediately from the investment to live off of or put into other investments.
Deferred Annuities
With a deferred annuity, you fund the contract with either a lump sum, a series of payments, or both, and you can choose to start income at a later date. This is ideal for someone who wants to save for retirement while also insuring against longevity risk.
Common categories of deferred annuities include fixed, fixed indexed, and variable—each differs in how value grows and what guarantees apply.
Fixed Deferred Annuity
A fixed deferred annuity pays a guaranteed rate of interest on your deposits.
The payments you receive in retirement will be based on the interest rate at the time you annuitize (start taking distributions).
Variable Deferred Annuity
A variable deferred annuity does not offer a guaranteed rate of interest.
However, the payments you receive in retirement will be based on the performance of the underlying investments.
Features Of Annuities
Annuities come with a variety of features that can be tailored to your specific needs.
Some common features include:
–Guaranteed income for life (optional): Some annuities can be structured to provide lifetime income, typically by annuitizing or via an income rider, subject to contract terms and limitations.
–Period certain (optional): This payout option guarantees payments for a set period; if the annuitant dies during that period, remaining payments generally go to the beneficiary for the rest of the period.
–Inflation protection: This feature adjusts your payments to keep up with inflation.
–Death benefit (varies): Many deferred annuities include a beneficiary provision if the owner dies during the accumulation phase, but the amount and rules depend on the contract and elected features.
What Are Some Of The Downsides To Annuities?
The biggest downside to annuities is that they are not liquid. If you need access to your cash, you will likely incur surrender charges from your provider.
Payout and inheritance depend on the options you choose. Some annuities can stop at death (e.g., life-only income), while others can be structured to continue for a minimum period (period-certain) or provide a refund feature, and many deferred annuities offer some form of beneficiary provision before annuitization.
If continuing income for a spouse is a goal, a joint-and-survivor payout can help, but it typically reduces the monthly payment compared with a single-life payout.
Another potential downside is that annuities are subject to market risk, depending on the nature of the annuity. This means that if the market falls a lot, your annuity value can go down.
However, if you have a fixed annuity, your monthly payments will not be affected by market fluctuations.
And finally, annuities have fees, which can include surrender charges, mortality and expense risk charges, administrative fees, and rider fees.
These fees can eat into your investment returns, so it’s important to understand all the fees associated with an annuity before investing.
In-plan annuity/lifetime-income options exist in some workplace retirement plans, but availability varies by employer and plan provider, and adoption can be limited due to cost, complexity, and fiduciary considerations.
Nonetheless, in December 2019, US President Donald Trump signed the Setting Every Community Up for Retirement Enhancement, SECURE Act, into law.
This bill loosened the rules as they pertain to how employers can select annuity providers and includes annuities within their 401(k) or 403(b) investment plans.
Annuities vs. Life Insurance
Annuities and life insurance are both insurance products, but they’re designed to solve different problems.
Annuities are typically used to convert savings into a stream of income (immediately or later), and many contracts offer tax-deferred growth on earnings until withdrawals/distributions are taken.
Life insurance is primarily designed to provide a death benefit to beneficiaries if the insured dies while the policy is in force. Some policies also build cash value, and product structures vary (including variable life products).
In practice, Annuities are usually considered when someone wants to secure retirement income or manage longevity risk, while life insurance is usually considered when someone wants to protect dependents or cover financial obligations in the event of death.
The biggest downside associated with annuities is that they are not liquid. If you need access to your cash, you will likely incur substantial penalties.
Another downside is that annuities are complex products, and it can be difficult to understand all the fees associated with them. It’s important to work with a financial advisor to make sure you understand the product before you invest.
An example of an immediate annuity is when an individual would pay a single premium – e.g., $100,000 – to an insurance company and receive monthly payments – e.g., $1,000 – for a fixed period of time afterwards.
The amount that’s paid out for immediate annuities depends on market conditions and interest rates.
IRA vs. Annuity – What’s The Difference?
An IRA is a type of tax-advantaged retirement account; an annuity is an insurance contract.
In the US, IRAs can provide tax advantages depending on the type (Traditional vs Roth). Annuities, by contrast, typically provide tax-deferred growth on earnings, with taxes generally due when you withdraw or receive payments (and earnings are typically taxed as ordinary income).
Key practical difference: An IRA is an account wrapper that can hold many investment types, while an annuity is a contract with insurer features (e.g., payout options, guarantees, riders, surrender charges).
Another key difference is that IRAs offer more flexibility than annuities.
With an IRA, you can choose how your money is invested. After age 59½, IRA distributions are generally no longer subject to the 10% additional tax on early withdrawals, though regular income tax may still apply, and other rules can still affect withdrawals.
With an annuity, withdrawals during the surrender period may trigger surrender charges, and withdrawals before age 59½ may also trigger an additional IRS tax penalty (depending on circumstances), so access can be more limited than in many brokerage accounts.
Which one is best for you?
If you’re looking for tax-deferred growth and flexibility, an IRA may be a good choice. If you’re looking for guaranteed income payments in retirement, an annuity may be a better choice.
Annuities In Day Trading
Annuities can be a great option for those who want to hedge the risks involved with potentially outliving their saved assets.
Day trading is an active form of asset management where traders are generally looking to take advantage of short-term movements in the market.
Even so, it can be beneficial for those with more active, higher-volume trading styles to set aside a portion of their income each month as savings in a longer-term portfolio, potentially in the form of an annuity.
Developing a nest egg or rainy day account as a complement to your active trading strategy can work to hedge risks and better secure your financial future.
FAQ
Who buys annuities?
Anyone who wants to ensure they have a steady income stream in retirement can buy an annuity.
Annuities are also popular with people who want to leave an inheritance to their family.
How do I know if an annuity is a good investment for me?
That depends on your individual financial situation and goals.
If you’re looking for income in retirement, an annuity may be a good option. If you’re looking for financial protection for your family, life insurance may be a better choice.
Is an annuity a good investment if I’m already retired?
Yes, annuities can be a good investment for those who are already retired and looking for income.
What are the different types of annuities?
There are two main types of annuities: immediate annuities and deferred annuities.
Immediate annuities start paying out income right away, while deferred annuities allow you to grow your money over time before taking income payments.
How does an annuity work?
An annuity is a contract with an insurance company that can provide income starting now or later. Whether payments continue after death depends on the payout option and features selected (e.g., life-only vs period-certain/refund options).
With an annuity, you make regular payments into the account and then receive payments back from the account at a later date.
What are the benefits of an annuity?
Some of the benefits of an annuity include:
- Guaranteed income payments for life
- Principal protection
- Tax-deferred growth
- Death benefit protection
What are the drawbacks of an annuity?
The biggest downside associated with annuities is that they are not liquid. If you need access to your cash, you will likely incur substantial penalties.
Another downside is that annuities are complex products, and it can be difficult to understand all the fees associated with them. It’s important to work with a financial advisor to make sure you understand the product before you invest.
How much does an annuity cost?
The cost of an annuity depends on the type of annuity, the features you choose, and the company you buy it from.
To get an idea of how much an annuity might cost, contact a financial advisor or insurance company.
When can I start taking money out of my annuity?
The date when you can start taking money out of your annuity depends on the type of annuity you have.
With a deferred annuity, you can often withdraw earlier than retirement, but doing so may trigger surrender charges and tax consequences; many people choose to start income later for retirement planning reasons.
With an immediate annuity, you can start taking income payments right away.
What are some things to consider before buying an annuity?
Some things to consider before buying an annuity include:
- Your age and health
- Your investment goals
- Your financial situation
- The type of annuity you want
- The company you want to buy the annuity from
It’s also important to understand all the fees associated with annuities before you purchase one.
What are some red flags to watch out for when buying an annuity?
Some red flags to watch out for when buying an annuity include:
- High fees
- Complex product features
- Pushy salespeople
It’s important to work with a financial advisor you trust to make sure you understand the product and aren’t being taken advantage of.
What are some of the risks and criticisms of annuities?
Deposits into annuities entail a lockup period, where funds generally can’t be withdrawn before a specified period.
If funds of a certain amount are drawn before the stated period, the annuitant would face a penalty.
Lockup periods can be 10 years or sometimes even longer, similar to other illiquid investments such as hedge funds, private equity, and venture capital. The sooner the funds are drawn, the greater the penalty tends to be.
This is instituted by issuers to better ensure that they’ll make a return on investment on these products (otherwise, there is no point in their offering the service).
Similarly, insurers will add costs to a product that demands earlier payment withdrawals, longer payout durations, accelerated payouts upon the triggering of some clause, risk hedging (e.g., inflation linkage, etc.), survivorship benefits, and other potential features that could conceivably increase the product’s present value of cash flows.
What is a non-qualified annuity?
A non-qualified annuity is an annuity that is not held in a qualified retirement plan, such as an IRA or 401(k).
Non-qualified annuities typically have fewer restrictions than qualified annuities, but they also may be subject to taxes.
It’s important to talk to a tax advisor to see if a non-qualified annuity is right for you.
What is a qualified annuity?
A qualified annuity is an annuity that is held in a qualified retirement plan, such as an IRA or 401(k).
Qualified annuities typically have more restrictions than non-qualified annuities, but they may also offer tax benefits.
It’s important to talk to a tax advisor to see if a qualified annuity is right for you.
What is a single premium annuity?
A single premium annuity is an annuity where you make one lump sum payment into the account.
Income from a single-premium annuity depends on pricing factors such as age, interest rates, payout options, and contract features, so outcomes vary by product and person.
What is a variable annuity?
A variable annuity is an annuity that allows you to invest your money in a variety of different investments, including stocks and bonds.
The value of your investment will fluctuate based on the performance of the underlying investments.
Variable annuities also typically have higher fees than other types of annuities.
What is an index annuity?
An index annuity is an annuity that is linked to a stock market index, such as the S&P 500.
A (fixed) indexed annuity is generally considered a type of fixed annuity where interest credited is linked to an external index (often with caps, participation rates, or spreads), typically with minimum guarantees set by the contract.
Fees and surrender charges vary widely by product and features, so it’s best to compare contract disclosures rather than assume a category is always lower-cost.
What is a fixed annuity?
A fixed annuity is an annuity that pays a fixed rate of interest.
The value of your investment will not fluctuate based on the performance of the underlying investments.
Fixed annuities typically have lower fees than other types of annuities, but surrender charges and optional rider fees may still apply.
What is an immediate annuity?
An immediate annuity is an annuity that allows you to start receiving income payments right away.
Income levels depend on pricing factors such as age, interest rates, payout options (single vs joint life, period-certain, inflation adjustments), and insurer assumptions.
What is a deferred annuity?
A deferred annuity delays income payments until a later date and typically includes an accumulation phase; it can be funded with a lump sum, ongoing payments, or both, depending on the contract.
The money in the account grows tax-deferred and can be used for retirement income or other purposes at a later date.
Fees vary widely across deferred annuities depending on type (fixed, fixed indexed, variable) and elected riders, so disclosures should be compared contract-by-contract.
What is an annuity fund?
In a variable annuity, your money is typically allocated among investment options (often called subaccounts) whose performance affects your account value.
In a fixed (or fixed indexed) annuity, returns are determined by the contract’s crediting method and the insurer’s general account, rather than by a fund you directly own.
What is the best age to buy an annuity?
There is no single answer to this question as it depends on your personal circumstances.
It’s important to talk to a financial advisor to see if an annuity is right for you and, if so, what the best age to buy an annuity would be.
Typically, annuities are purchased by those who are near or in retirement.
What is the surrender period?
The surrender period is the length of time that you are required to keep your money in the annuity before you can withdraw it without incurring a penalty.
Surrender periods vary by contract and can last for multiple years; details are spelt out in the annuity’s disclosure documents.
Summary
Annuities are insurance contracts that can be used to generate income in retirement.
They are contracts between an investor and an insurance company, under which the investor makes periodic payments into the account.
In return, the insurance company agrees to make income payments to the investor for a set period of time, or for the rest of their life.
Annuities are illiquid. Deposits into annuity contracts are usually locked up for a period of time, which is known as the surrender period.
In these cases, the annuitant would incur a penalty if all or part of that money were taken.
Annuities are also subject to market risk. This means that if the market falls a lot, your annuity value can go down. However, if you have a fixed annuity, your monthly payments will not be affected by market fluctuations, though you’ll still be subject to the credit risk associated with the company paying you the annuity.
And finally, annuities have fees which can include surrender charges, mortality and expense risk charges, administrative fees, and rider fees. These fees can reduce investment returns, so it is important to understand all the fees associated with an annuity before investing.
An annuity can be a great option for those who want to hedge the risks involved with potentially outliving their saved assets.
Even so, it can be beneficial for those with more active trading styles to set aside a portion of their income each month as savings in a longer-term, well-balanced portfolio, potentially in the form of an annuity.
Developing a nest egg or rainy day account that serves as an additional source of reliable income as a complement to a more active trading strategy or separate investment plan can work to hedge risks and better secure your financial future.