What Is an Annuity and How Does It Work?

By Laurel Tincher · April 11, 2023 · 9 minute read

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What Is an Annuity and How Does It Work?

We hear a lot about retirement savings options like IRAs and 401(k) plans, but a less talked about investing strategy for retirement is buying an annuity. An annuity is a contract with an insurance company. The buyer pays into the annuity for a certain number of years, at which point the company pays back the money in monthly payments.

An annuity guarantees a certain amount of monthly income in retirement. In essence, buyers pay the insurance company to take on the risk of them outliving their retirement savings. There are both pros and cons to annuities, as well as a number of types of annuities you can buy.

How Does an Annuity Work?

After signing up for an annuity, the account holder begins making payments, either over time or as a lump sum. The years of paying into an annuity are known as the accumulation phase. Sometimes, the payments can be made from an IRA or 401(k).

The money paid into the annuity account may be invested into the stock market or mutual funds, or it might earn a fixed interest rate over time.

Money paid into the annuity can’t be withdrawn for a certain amount of time, called the surrender period. After the accumulation phase is over, the company begins making regular income payments to the annuity owner. This is known as the distribution phase, or amortization period. Similar to 401(k) accounts, annuity payments begin after age 59 ½; a penalty may apply to withdrawals made before this.

One can choose the length and start date of the distribution phase. For example, you might choose to receive payments for 10 years, or perhaps you prefer guaranteed payments for the rest of your life. Terms and fees depend on the structure of the distribution phase.

Types of Annuities

The main annuity categories are fixed, variable, and indexed, but within those types there are various options and subcategories.

Fixed Annuities

The principal paid into a fixed annuity earns a fixed amount of interest, usually around 5%. Although the interest is typically not as high as the returns one might get from investing in the stock market, this type of annuity provides predictable and guaranteed payments.

Variable Annuities

This type of annuity lets buyers invest in different types of securities, usually mutual funds that hold stocks and bonds. Although this can result in a higher payout if the securities do well, it also comes with the risk of losing everything. Some variable annuities do come with a guarantee that investors will at least get back the money they put in.

Indexed Annuities

An indexed annuity is pegged to a particular index, such as the S&P 500. How the index performs will determine how much the annuity pays out. Usually, indexed annuities cap earnings in order to ensure that investors don’t lose money.

For example, they might cap annual earnings at 6% even if the index performed better than that. But then in a bad year, they would pay out 0% earnings rather than taking a loss, so investors would still receive their base payment amount.

Immediate Annuities

With immediate annuities, investors begin receiving regular payments almost as soon as they open an account. Immediate annuities can be expensive.

Deferred-Income Annuities

This type of annuity, also called a longevity annuity, is for people who are concerned they might outlive their retirement savings. Investors must wait until around age 80 to begin receiving payments, but they are guaranteed payments until they die.

The monthly payouts for deferred-income annuities are much higher than for immediate annuities, but risk is involved. If the investor dies before starting to receive payments, heirs do not receive the money in the annuity account. Married couples might opt for a joint-life version, which has lower monthly payouts but continues payments for as long as either spouse lives.

There is also a deferred annuity called a qualifying longevity annuity contract, which is funded all at once from an investor’s IRA or 401(k). One can invest up to 25% of the money from retirement accounts, or a maximum of $200,000.

Equity-Indexed Annuities

With equity-indexed annuities, investors receive a fixed minimum amount of income. That amount may increase if the index the annuity is pegged to increases.

Fixed Period Annuities

Fixed period annuities allow buyers to receive payments for a specific number of years.

Retirement Annuities

With retirement annuities, investors pay into the account while still working. Once they retire, they begin receiving payments.

Direct-Sold Annuities

These annuities have no sales commission or surrender charge, making them less expensive than other types of annuities.

Pros of Annuities

There are several reasons people choose to pay into annuities as part of their retirement plan. The upsides of annuities include:

•   Guaranteed and predictable payments: Depending on the annuity, a guaranteed minimum income benefit can be set for a specific number of years or for the buyer’s life. Payments may even be made to a buyer’s spouse or other beneficiary in case of death.

•   Tax-deferred growth: Interest earned on annuity deposits is not taxed immediately. Annuity owners generally don’t pay taxes on their principal investment; they pay income taxes on the earnings portion in the year they receive payments.

•   Low-stress management: The annuity company uses an annuity formula to figure out how much each payment should be and to keep track of account balances. All the investor has to do is pay into the account during the accumulation phase.

•   No investment limits or required minimum distributions: Unlike an IRA or 401(k), there is no limit to the amount of money that can be invested into an annuity. Further, there is no specific age at which investors must begin taking payments.

•   Option to bolster other retirement savings: For those closer to retirement, an annuity may be a good option if they’ve maxed out their other retirement savings options and are concerned about having enough money for living expenses.

Cons of Annuities

Like any type of investment, annuities come with downsides:

•   Lower interest compared to stocks or bonds: The interest earned by annuities is generally lower compared to what investors would earn in the stock market or bonds.

•   Penalty for early withdrawals: Once money is invested in an annuity, it can’t be withdrawn without a penalty until age 59 ½.

•   Fees: Annuities can have fees of 3% or more each year. There may also be administrative fees, and fees if the investor wants to change the terms of the contract. It’s important before buying an annuity to know the fees attached and to compare the costs with other types of retirement accounts.

•   Possible challenges in passing on the money: If investors die before they start receiving payments, they miss out on that income. Some annuities pass the money on to heirs, but others do not. There may be a fee for passing the money on.

•   Potential to lose savings in certain circumstances: If the insurance company that sold the annuity goes out of business, the investor will most likely lose their savings. It’s important for investors to research the issuer and make sure it is credible.

•   Inflation isn’t factored in: Annuity payments usually don’t account for inflation. However, some annuities pay out higher amounts over time to account for cost of living increase.

•   Risk: Variable annuities in particular are risky. Buyers could lose a significant amount, or even all of the money they put into them.

•   Complexity: With so many choices, buying annuities can be confusing. The contracts can be dozens of pages long, requiring close scrutiny before purchasing.

What Are Annuity Riders?

When investors buy an annuity, there are extra benefits, called riders, that they can purchase for an additional fee. Optional riders include:

•   Lifetime income rider: With this rider, buyers are guaranteed to keep getting monthly payments even if their annuity account balance runs out. Some choose to buy this rider with variable annuities because there’s a chance that investments won’t grow a significant amount and they’ll run out of money before they die.

•   COLA rider: As mentioned above, annuities don’t usually account for inflation and increased costs of living. With this rider, payouts start lower and then increase over time to keep up with rising costs.

•   Impaired risk rider: Annuity owners receive higher payments if they become seriously ill, since the illness may shorten their lifespan.

•   Death benefit rider: An annuity owner’s heirs receive any remaining money from the account after the owner’s death.

How to Buy Annuities

Annuities can be purchased from insurance companies, banks, brokerage firms, and mutual fund companies. As mentioned, it’s important to look into the seller’s history and credibility, as annuities are a long-term contract.

The buyer can find all information about the annuity, terms, and fees in the annuity contract. If there are investment options, they will be explained in a mutual fund prospectus.

Some of the fees to be aware of when investing in annuities include:

•   Rider fees: If you choose to buy one of the benefits listed above, there will be extra fees.

•   Administrative fees: There may be one-time or ongoing fees associated with an annuity account. The fees may be automatically deducted from the account, so contract holders don’t notice them, but it’s important to know what they are before sealing the deal.

•   Penalties and surrender charges: An annuity owner who wants to withdraw money from an account before the date specified in the contract will be charged a fee. Owners who want to withdraw money before age 59 ½ will be charged a 10% penalty by the IRS as well as taxes on the income from the annuity.

•   Mortality and expense risk charge: Generally annuity account holders are charged about 1.25% per year for the risk that the insurance company is taking on by agreeing to the annuity contract.

•   Fund expenses: If there are additional fees associated with mutual fund investments, annuity owners will have to pay them as well.

•   Commissions: Insurance agents are paid a commission when they sell an annuity. Commissions may be up to 10%.

Building Your Portfolio

No matter what stage of life you’re in, it’s not too early or too late to build an investment portfolio. Younger investors may not be ready to buy into an annuity, but they can still start saving for retirement. For those who are considering an annuity as a retirement investment, it’s important to weigh both the pros and cons. Carefully evaluate the seller, any offered riders, and the fees associated with the annuity.

If you’re feeling torn on where to invest your money, that’s understandable. With so many investing options available, it can be overwhelming to decide how to begin. Fortunately, there are easy-to-use platforms like SoFi Invest®, which offers a full suite of investing tools right at your fingertips.

With just a few clicks, you can buy and sell stocks and build a portfolio. It’s also possible to research and track favorite stocks, set personalized financial goals, and see all of your accounts in one place. SoFi offers active investing, where you pick and choose each security you want to invest in, or automated investing.

Take a step toward reaching your financial goals with SoFi Invest.


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