What Is an Annuity?

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What Is an Annuity?

Let me explain what an annuity is: it's a contract issued and distributed by an insurance company that you buy as an individual. In return for your premiums, the company pays you a fixed or variable income stream, starting either right away or sometime in the future. This isn't like life insurance, which only pays out when the insured dies.

You invest in annuities through monthly premiums or a lump-sum payment, and the institution then provides payments for a set period or for the rest of your life. These are mainly for retirement income, helping you manage the risk of outliving your savings.

Key Takeaways on Annuities

Annuities are financial products that guarantee an income stream, typically for retirees. The accumulation phase is when you fund it with lump sums or periodic payments. Once annuitization starts, you receive payments for a fixed time or life. They come in various types, offering flexibility, and can be immediate or deferred, fixed, variable, or indexed.

How Annuities Work: Accumulation vs. Payout Phases

Annuities are built to give you steady cash flow in retirement, easing worries about running out of money. If your assets might not last, you can turn to an insurance company for this contract. It's suitable if you're an annuitant seeking stable, guaranteed income, but remember, the cash is illiquid with withdrawal penalties, so it's not ideal if you're young or need quick access to funds.

Phases of an Annuity

An annuity goes through phases. The accumulation phase is when you're funding it, and your money grows tax-deferred before payouts. Then comes the annuitization or payout phase, where payments to you begin.

Immediate vs. Deferred Annuities: Choosing Your Timing

You can choose immediate annuities, often bought with a lump sum like a settlement, exchanging it for future cash flows. Deferred annuities grow tax-deferred and start income on a date you pick.

Regulation of Annuities

Variable annuities are regulated by the SEC and state insurance commissioners. Fixed annuities fall under state insurance commissioners, not the SEC. Indexed annuities are usually state-regulated, but if registered as securities, the SEC steps in too. FINRA oversees variable and registered indexed ones. Sellers need a state life insurance license, and for variables, a securities license; they earn commissions based on the contract's value.

Annuities have complex tax rules, so consult a professional before buying.

Other Considerations: Surrender Period and Withdrawals

Annuities often have a surrender period lasting years, where withdrawing incurs charges. Think about your financial needs during this time—if you have big expenses coming up, assess if you can afford the payments. Many allow up to 10% withdrawal without fees, but more could trigger penalties, even after the period, and taxes if before age 59½.

If you're in a bind, you might sell your payments for a lump sum, giving up future income. Contracts can include income riders for fixed income post-annuitization; check the age you need income and any fees involved. You can't outlive the stream, hedging longevity risk, but you're trading liquidity for guarantees. Don't plan to cash out for profit—that's not their purpose.

Annuities in Workplace Retirement Plans

Annuities can fit into retirement plans but are complex, so many employers skip them. The SECURE Act in 2019 eased rules, giving employers more options to include them in 401(k)s or 403(b)s, potentially leading to more employee investments.

Types of Annuities: Fixed, Variable, Indexed, Immediate & Deferred

Annuities vary by payout duration, like continuing for your life or a spouse's with survivorship, or for a fixed period like 20 years. They can start immediately after a lump sum or be deferred. With immediate, payments begin right away; deferred let you pick a start age. Depending on type, you might recover principal or not—lifetime payouts often don't refund, while fixed periods might for heirs.

Fixed annuities guarantee interest and payments. Variable ones tie to investments, offering higher potential but risk of lower payments. Indexed link to an index like the S&P 500. Variables have market risk but can add riders for hybrids, death benefits, or inflation adjustments.

Criticism of Annuities

Critics note annuities are illiquid, with deposits locked during surrender periods of 2 to over 10 years, starting penalties at 10% and declining. They're complex and costly, so research fees and penalties thoroughly. The 2024 Retirement Security Rule aims to make advisors act in your best interest, but it's facing litigation from the insurance industry.

Annuities vs. Life Insurance

Life insurance handles mortality risk, paying on death after premiums. Insurers profit if policyholders live long. You can exchange permanent life cash value for an annuity tax-free via 1035. Annuities handle longevity risk, with issuers hedging by selling to higher-risk customers.

Examples of Annuities

A fixed annuity might involve monthly payments until age 59½, then retirement income. Or, pay $200,000 lump sum for immediate $5,000 monthly for a fixed time, based on rates.

Who Buys Annuities?

If you want stable retirement income and can handle illiquidity, annuities suit you. Not for the young or those needing liquidity. They hedge longevity risk.

What Is a Non-Qualified Annuity?

Non-qualified are bought with after-tax dollars; qualified with pre-tax, like in 401(k)s. Only earnings are taxed on withdrawal for non-qualified.