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How Do Annuities Work?

As a financially savvy person, you probably already have a diverse retirement investment portfolio. Mutual funds, bonds, and 401(k) can safeguard your finances once you retire and enjoy your well-deserved rest. But what about annuities? Have you considered adding them to your portfolio as well? Since you’re here, we assume you have.

The question that may spring to mind, though, is how do annuities work? After all, understanding how annuities work is crucial for making informed decisions about your financial future. In this guide, we will explain the basics of how annuities and different types of annuities work, as well as how to buy an annuity that suits your needs.

What Are Annuities?

Simply put, annuities are financial products that provide a regular income stream over a specified period or for the rest of your life. They are often used as a retirement planning tool to ensure a steady income flow once a person retires. Annuities are typically sold by life insurance companies and can be funded through a lump sum payment or regular contributions over time.

How Do Annuities Work?

When you purchase an annuity, you essentially enter into a contract with an insurance company. In exchange for your premium payments, which can be made in a single lump sum or through periodic contributions, the insurance company promises to pay you a regular income for a specified period or for the rest of your life. This steady income can be paid out monthly, quarterly, annually, or in any other agreed-upon frequency.

The amount of income you receive from an annuity depends on various factors, such as the type of annuity you choose, the amount of your initial investment, the annuity’s terms and conditions, and the prevailing interest rates at the time of purchase. Some annuities offer fixed payments, meaning the income remains constant over the payout period. Others may provide income that increases over time to account for inflation or changes in the market.

Types of Annuities

There are five main types of annuities: immediate annuities, deferred annuities, fixed annuities, variable annuities, and indexed annuities. Each type has its own characteristics and benefits, so it’s important to understand how they differ from one another and how they work before settling up for one specific type.

Immediate Annuity

Immediate annuities are designed to provide a regular income stream starting immediately after the annuity contract is purchased. They are often used by individuals who want to convert a lump sum of money, such as retirement savings, into a steady income for the rest of their lives.

When purchasing an immediate annuity, you pay a premium to an insurance company, which then guarantees a fixed monthly or annual payment for a specified period or for the rest of your life. The payment amount will depend on such factors as the initial premium, your age, life expectancy, and current interest rates.
Immediate annuities are particularly popular among retirees looking for a stable income source to cover their living expenses.

Deferred Annuity

Deferred annuities provide individuals with a way to accumulate funds over a specified period before receiving regular payments in the future. These annuities are often used as part of a long-term retirement savings strategy. How do they work?

Essentially, when purchasing a deferred annuity, the individual makes regular premium payments to an insurance company. These payments accumulate and earn interest over time, allowing the annuity to grow. The individual can choose from various investment options offered by the insurance company, such as fixed interest rates or market-linked returns.

During the accumulation phase, the funds within the annuity grow tax-deferred. And once you reach a certain age or a predetermined date, you will start receiving regular payments, either in a lump sum or as a series of payments.

Fixed Annuity

A fixed annuity guarantees a fixed rate of return on your investment for a specified period. The insurance company assumes the risk and responsibility of investing the funds and paying out a predetermined amount to the annuity holder. With a fixed annuity, you know exactly how much income you will receive each month, making it a popular choice for individuals seeking stability and predictability.

The fixed rate of return offered by fixed annuities can be attractive to conservative investors who prioritize safety and security over the potential for higher returns. These annuities provide a sense of certainty as your principal investment is protected, and you receive a guaranteed income throughout the term of the annuity. However, it’s important to note that fixed annuities may not keep pace with inflation, which can erode the purchasing power of your income over time.

Variable Annuity

Unlike a fixed annuity, a variable annuity allows you to invest your money in various investment options, such as mutual funds or stocks. The return on your investment is tied to the performance of these underlying investments, meaning it can fluctuate over time. While variable annuities offer the potential for higher returns, they also come with more risk and uncertainty.

Variable annuities are suitable for people willing to take on investment risk in exchange for the potential for greater returns. They allow you to participate in the ups and downs of the market, meaning your income can vary depending on how well the investments within the annuity perform. Variable annuities often come with a greater degree of flexibility, allowing you to choose from a range of investment options and potentially customize your income stream.

However, it’s important to consider that variable annuities may have higher fees and expenses compared to other types of annuities. These fees can impact your overall returns and should be carefully evaluated before making a decision.

Indexed Annuity

Indexed annuities are a hybrid of fixed and variable annuities. The return on your investment is tied to the performance of a specific market index, such as the S&P 500. Indexed annuities provide the opportunity to participate in market gains while also offering downside protection, ensuring you won’t lose your principal investment even if the index performs poorly.

Indexed annuities are suitable for those who want to benefit from market upside potential while still having some level of protection against market downturns. These annuities often come with a cap or participation rate, limiting the amount of market upside you can earn but also protecting you from significant losses. Indexed annuities can appeal to those seeking a balance between growth potential and capital preservation.

It’s important to note that indexed annuities may have limitations and restrictions, such as caps or long surrender periods. Understanding the terms and conditions of the indexed annuity is crucial before making a purchase decision.

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Who Should Consider Buying an Annuity?

Annuities can be a suitable financial product for individuals concerned about outliving their retirement savings or who want to ensure a stable income stream. If you are looking for a guaranteed income and are willing to trade potential higher returns for stability, an annuity may be a good fit for you.

Annuities are particularly beneficial for individuals who don’t have access to a traditional pension plan or have exhausted their contributions to other retirement accounts such as 401(k)s or IRAs. Annuities can provide an additional tax-deferred savings vehicle to supplement your existing retirement savings.

Additionally, annuities can be suitable for conservative investors who prioritize capital preservation and are not comfortable with the stock market’s volatility. Annuities offer a way to generate a steady income stream without worrying about market fluctuations.

However, it’s essential to assess your individual financial situation and goals before purchasing an annuity. Consider factors such as your age, risk tolerance, income needs, and other sources of retirement income. Consulting with a financial advisor can help you determine if an annuity is the right choice for your specific circumstances.

How to Buy an Annuity?

Buying an annuity requires careful consideration and research. Here are some important steps to follow when purchasing an annuity:

Ensure You Have Enough Money

Before buying an annuity, assess your financial situation and determine if you have enough money to commit to an annuity. Consider your current and future expenses and any other sources of retirement income you may have. An annuity should complement your overall retirement plan rather than be your sole source of income.

Choose the Best Annuity for Your Needs

Research the different types of annuities and evaluate which one aligns with your financial goals and risk tolerance. Some factors to consider when evaluating annuities include:

  • Fees: Different annuities may come with various fees, such as administrative fees, mortality and expense charges, and optional riders. These fees can impact the overall returns of the annuity, so it’s important to understand them and compare them across different products.
  • Surrender Charges: Some annuities may have surrender charges if you withdraw your money early or make excessive withdrawals. Understanding the surrender charge schedule is crucial, as it can limit your liquidity during the surrender period.
  • Financial Strength of the Insurance Company: Annuities are long-term contracts, so choosing a reputable insurance company with a strong financial foundation is vital. Research the financial ratings of the insurance company and assess their ability to meet their obligations.

Structure Your Annuity Payments

Annuities offer flexibility in how you receive your payments. You can choose to receive a fixed income for a specified period, opt for a lifetime income, or select a combination of both. It’s important to consider your longevity expectations, financial needs, and any potential beneficiaries when deciding how to structure your annuity payments.

If you choose a fixed income option, you will receive a predetermined amount at regular intervals, such as monthly or annually, for a specific duration. This option provides a steady income stream but may not keep up with inflation over time. Fixed income options can be beneficial if you have specific expenses or financial commitments that require a stable income.

If you opt for lifetime income, the annuity will continue to pay out for as long as you live. This provides protection against longevity risk, ensuring you won’t outlive your savings. However, the initial income amount may be lower compared to a fixed-term annuity. Lifetime income options can be beneficial if you are concerned about the possibility of outliving your retirement savings or if you have a longer life expectancy.

You can also choose a combination of fixed and lifetime income options to strike a balance between stability and longevity protection. This approach allows you to receive a certain level of guaranteed income for a specified period and then transition to lifetime income once that period ends. This can provide you with flexibility, allowing you to meet your short-term financial needs while still ensuring long-term financial security.

Speak to a Financial Advisor

Going through all this information can be overwhelming. That is why Annuity Association has come up with an elegant solution. Instead of going through all the necessary annuity-related information, we bring you all the essential data about the annuity marketplace. Schedule your financial advice with us today, and let us help you build a plan to protect your retirement savings tailored perfectly to your specific needs.

Key Takeaways

By understanding the basics of annuities and evaluating your specific circumstances, you can make educated choices that align with your retirement goals. Annuities may not be suitable for everyone, so it’s important to assess your own needs, risk tolerance, and financial capabilities before purchasing an annuity. Working with a financial advisor like Annuity Association can help ensure that you make the best decisions for your individual situation.

Jeremiah Konger
Jeremiah Konger
CEO at Annuity Association

Jeremiah understood his whole life the importance of community and caring for those who are a part of it. Starting his first business venture at the age of 23, he gained invaluable experience in working with others for a joint purpose.
He founded his first wireless retail business in 2011, expanding it from one store to 12 locations across the state in just three years.
Once he sold his company, Jeremiah began the journey he’s on today, using his talents and experience to work with seniors in order to help them find the best means of financing their retirement plans.

He’s found his true calling working as a proud member of the Annuity Association, assisting retirees in building their safe financial future.