What Are Annuities and How Do They Work?

An annuity is a financial product that pays out a fixed amount of money, usually in a series of payments. Annuities are popular — sales of annuities increased by 22% in 2022 as compared to 2021 results, according to Limra. This increase happened in response to rising interest rates, which remain high in 2024. They are also polarizing — a quick Google search reveals a number of websites warning you to stay away from annuities.

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Despite the debate, annuities serve a purpose. These products were designed specifically to provide guaranteed income, which is one reason you may decide to include one in your retirement plan. However, annuities are complex products that come in a variety of distribution structures and might include add-ons called riders. Learning more about annuities and how they work can help you understand their role in helping you prepare for the rest of your life.

What Is the Purpose of an Annuity?

The primary function of an annuity is to remove longevity risk for retirees. Many people are frightened by the prospect of outliving the money they accumulate during their working years. As the average life span increases and the number of pensions decreases, this fear has become a real problem for financial planners.

The situation is exacerbated by fears that the Social Security system won’t have enough money to cover future generations that retire. Annuities, therefore, can be useful tools to transfer longevity risk from individuals to insurance companies. Even with their apparent advantages, however, annuities also have potential downsides that might make them unsuitable for certain people.

What Is an Annuity?

An annuity is a contract between up to four parties:

• Owner: The owner is the person who buys the annuity.

• Annuitant: The annuitant is the one who gets the benefit payments and is often the same as the owner.

• Beneficiary: The beneficiary receives death benefits payable under the annuity contract, if applicable.

• Issuer: The issuer is the company that issues the annuity, such as an insurance company, and pays benefits when the time comes.

Payment amounts in the distribution phase are based on the annuitant’s life expectancy.

How Do Annuities Work?

Annuities are divided into two phases:

• Accumulation phase: The accumulation phase is the period during which contributions are made to the account and funds grow. Appreciation during this time is based on contractual guarantees or investment performance, depending on the type of annuity purchased.

• Annuitization phase: This is when payments start being made to the annuitant. These payments can be a lump sum, periodic payments or some combination of the two. The amount paid out is determined by the amount contributed, the performance of the account, the expected life span of the annuitant and the type of distribution elected by the owner.

Annuity Payments

Annuities come with several distribution structures that outline how you receive your payments. The most common options include life only, joint and survivor life, fixed amount and fixed period. Here’s how they compare:

• Fixed amount: You receive payments in a fixed amount until you have no money left in the annuity or you request them to stop. This option does not provide guaranteed income for the rest of your life, but it does give you a predictable income stream.

• Fixed period: You receive payments for a specific length of time, such as 10 or 20 years. If you die before the period ends, your beneficiary can receive the rest of the contracted payments.

• Joint and survivor life: You or your survivor receive guaranteed payments for the rest of your lives. With this structure, you receive the payments until your death. At that point, your survivor receives the payment you agreed to for the rest of their life.

• Life only: You receive guaranteed payments for the rest of your life. This doesn’t mean you automatically get back all of the money in the annuity, but you’ll have a regular payment that you can count on. Your life expectancy plays a factor in how much you’ll receive — the longer you’re expected to live after payments start, the smaller they’ll be.

A certain option triggers payouts for a defined amount of time — even if the annuitant passes away before that period is reached. Annuity assets can also be distributed in lump sums.

Types of Annuities

Numerous types of annuities are available, as well as different options and contractual terms that can impact outcomes. You’ll want to consider each of these features before committing to an annuity contract. Prospective annuity buyers should also consider the suitability of these vehicles as they relate to financial goals and needs.

Take a look at some of the types of annuities that might be options for you.

Fixed Annuities

Fixed annuities are offered by life insurance companies and are contracts in which a policy owner contributes a certain amount of capital to an account. The insurance company makes a contractual guarantee that this capital will grow at a specified rate of return over time. In turn, the annuitant will be entitled to a set amount of periodic income during the distribution phase.

Fixed annuities are primarily designed to provide a modest growth vehicle that is insulated from the volatility of equity and bond markets, and to provide guaranteed income in retirement.

Variable Annuities

Variable annuities do not offer the guaranteed growth rates of fixed annuities. Instead, contract holders can access these accounts by allocating contributed funds across equities, bonds, money market products and mutual funds.

When the contract enters the distribution phase, the insurance company will provide guaranteed income based on the asset levels achieved in the capital subaccounts.

Prospective buyers of variable annuities should be aware that the value of their assets in these products can decline when market conditions deteriorate, so they might not be ideal solutions for people worried about losing money in an annuity.

Indexed Annuities

An indexed annuity is another type of annuity contract that blends characteristics of fixed and variable contracts. These products pay interest rates dictated by security indexes such as the S&P 500.

Indexed products offer higher growth potential relative to fixed vehicles and more downside protection than fully variable products. However, this downside protection doesn’t always prevent the account from producing net losses because the contractual floor might fall below the gross contributions.

Immediate and Deferred Annuities

The annuities mentioned above can also be classified as immediate or deferred.

Immediate annuities provide a guaranteed stream of income directly following a lump sum payment to the insurance company. This compresses the accumulation phase to a single contribution, with the distribution phase starting immediately.

Deferred annuities push the distribution phase out into the future, allowing one or multiple contributions to grow during the accumulation and investment phase.

These products are often structured as tax-deferred vehicles. They allow gains on the account to compound without any tax liability until qualifying withdrawals are made beyond retirement age.

Is an Annuity a Good Investment?

An annuity could be a good investment for some individuals, but there’s a lot to consider before you buy one. First, an annuity is not generally considered an investment like stocks and bonds. It is an insurance contract, and you buy one from an insurance company. Variable and index annuities are an exception because the value of the annuity is tied to the performance of the stock market. For this reason, anyone selling a variable annuity product must have a securities license.

Second, you have to consider factors like your overall retirement plan, your risk tolerance, and the benefits you will receive from the annuity. An annuity is not a substitute for a 401(k) and/or an individual retirement account, and it should not be your only source of retirement income. If the insurance company underwriting the annuity goes out of business, you may not be able to recover your money. Keep in mind that withdrawing money from the annuity early can lead to a loss.

The questions below might be some of the things you’re wondering about in regard to annuities and whether they are the right product for you.

What Are the Benefits of an Annuity?

Prospective annuity buyers should consider the advantages of these products and their suitability for their financial needs.

• Mitigate longevity risk

• Can protect against market declines

• Provide tax-deferred gains

• Boost income benefit by a set percentage

• Give you access to the money in your annuity when you need it

• Provide a higher interest rate to increase potential earnings

• Pay for the cost of nursing home or home health care

• Guarantee a minimum income

What Are the Disadvantages of an Annuity?

Annuities have some drawbacks as well.

• Equity-based annuity gains limited to percentage of market gains

• Must usually pay a surrender fee, and possibly tax penalties, for early withdrawal of funds

• High expenses, including commissions and management fees

• Can achieve similar returns at lower cost with other investment and savings options

Final Take

Ultimately, suitability is the most important consideration in any investment. If capital growth is a priority, fixed annuities are not going to be the most efficient solution. If limiting volatility is the priority, variable annuities are unlikely to be the most appropriate product, either.

Retirees who have accumulated sufficient assets to generate ample cash flow from interest and dividends are often able to self-insure against longevity risk. When assessing the merits of annuity products and how they might fit into your financial plans, you’ll want to consider all of the above features with respect to your own needs and goals.

FAQ on Annuities

Here are the answers to some commonly asked questions about annuities.

• Can you lose money in an annuity?

  • Fixed annuities are considered relatively safe assets. As outlined above, they offer contractual guarantees from insurance companies, and account values only increase over time.

  • Fixed annuities are only at risk of loss if an early surrender carries charges and penalties or if the insurance company becomes insolvent. Even in the case of insolvency, there is an industry organization designed to protect account holders that insures up to $250,000 of present value.

  • Variable and indexed annuities are subject to the same risks, but they also carry market risk and could theoretically lose value if there is poor performance from the subaccounts they are designed to track.

• How much does a $100,000 annuity pay per month?

  • How much an annuity pays per month depends on several variables, including your age, your gender, the type of annuity, how much you're contributing and the payment structure. A 60-year-old woman opening an annuity with a single $100,000 contribution, with the first payment starting in 30 days, could receive as much as $556 per month for the rest of her life at current rates as of April 10.

• How much does a $100,000 annuity pay per year?

  • Using the same assumptions as with the per-month example, the woman would receive about $6,680 per year.

• How much does a $50,000 annuity pay per month?

  • Again using the same assumptions, a $50,000 annuity could result in monthly income of about $278, or yearly income of about $3,340, at current rates.

Daria Uhlig, Allison Hache and Cynthia Bowman contributed to the reporting for this article.

Information is accurate as of April 10, 2024.

This article has been updated with additional reporting since its original publication.

This article originally appeared on GOBankingRates.com: What Are Annuities and How Do They Work?