What is an annuity?

byAnnuityRatesHQ Staff

Sun Feb 18 2024

Staff @ AnnuityratesHQ
What is an annuity?

An annuity is a purchased contract between the owner and an insurance company. The contract offers a promise of income for the purchaser during their retirement. Annuities are made up of paid-in principal plus earnings, which are then paid out of the remaining portion of the owner’s lifetime.

Annuities are just one of many products available for retirement income. They work differently than typical retirement accounts because they are an insurance product. Let’s dive into annuities and what they’re all about.

How Does an Annuity Work?

Annuities are a contract between you and an insurance company. You agree to pay into an annuity for a specific amount of time. Once you retire, you then annuitize your account–meaning converting it to payout to you.

With the shift from pensions to 401(k) retirement accounts in the 1980’s, people have lost their assured retirement funds. Rather than your employer paying you monthly for your dedication to their company–you are in charge of saving and managing your own retirement accounts. Annuities are a popular option for people who want a guaranteed income stream during their retirements.

Annuities will follow this lifecycle:

Purchase: Typically you will purchase from an insurance company. You may also be able to purchase them from brokerage firms, independent insurance agents, and financial planners. Occasionally, a bank may offer annuities.

Funding: Once purchased, you will need to determine how to fund your annuity. Usually annuities are funded with either an upfront lump sum payment or smaller payments that are made over several months/years.

Accumulation: This phase is when your funds will be building before payout. Depending on the type of account, your funds will be invested and begin to accumulate interest. Your contract will most likely state how long and/or how much needs to be contributed before you’re able to receive payments.

Annuitization: This is when you convert your annuity from accumulation into making payments to you. You must annuitize your account in order to begin receiving payouts from the annuity

Payout: Once you annuitize, payouts should start. The type of annuity and contract details will dictate the amount and frequency of your payments.

What Type of Annuity Should I Get?

Annuities come in all shapes and sizes–you can really tailor them to your financial needs. Typically the more complicated the annuity is, the more expensive it can be. Here are some of the common annuity types.

Single or straight life annuity, offers payment for the retiree as long as they’re alive. Unlike traditional retirement accounts, you cannot outlive a single life annuity. Even if you live beyond your life expectancy or account balance, the insurance company will continue to make payments. The insurance company assumes the risk and liability of making payments, should you live beyond your assumed lifespan.

Period certain annuities offer payments that are tied to a specific amount of time, rather than a specific person. If the owner of the annuity dies, payments will continue to be made to their designated beneficiary or estate. Payout amounts may be smaller on this product due to the guaranteed timeline.

Fixed annuities offer safe and predictable payouts. This type of contract states that payment amount and that payot doesn’t fluctuate with the market performance or conditions. The payment amounts may be smaller but for those who are risk averse, this is the type of annuity that you’ll want.

What are the benefits and drawbacks of annuities?

Everyone’s personal financial situation is going to be different. You should work with a financial advisor to determine how much retirement income you will need and how an annuity could be to your benefit. Just like any retirement product, there are upsides and downsides. Depending on your goals, an annuity may or may work for you. Here’s an overview on the benefits and drawbacks of annuities:

Benefits of Annuities

  • Guaranteed income during retirement years
  • No limits of how much you can invest
  • Tax deferred growth
  • No record keeping needed
  • Protection from market volatility

Drawbacks of Annuities

  • Limited liquidity
  • Management fees
  • Income ends with owner death, unless specified

Bottom Line

Annuities vary widely in their cost and terms–which make them a versatile retirement product to consider. Because of the predictable income they produce, annuities can play an important role for retirees who are looking to create a secure financial landscape during their golden years. Annuities are often criticized but that’s often because they are misunderstood. Work with a certified financial planner to better help you decide which annuity product would be best for you and your individual situation.