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What Is an Annuity?

Thinking about retirement can be a worrisome prospect. Although the thought of not returning to your 9-5 can be a relief, thinking about whether you have a solid plan or enough savings to last your retirement can be a heavy burden. One popular financial retirement option to help alleviate those concerns is an annuity.

Below, we will dive into what an annuity is, different types of annuities, how they work, and the benefits of having an annuity.

What Is an Annuity?

Annuities are long-term contracts between an individual and their insurance company. They are an investment that provides retirement security by issuing the individual regular payments in the form of income. They are designed to help protect you from the risk of outliving your income.

Annuities help financially secure individuals by making sure they don’t outlive their savings. This means that annuities are a great option for those going into retirement who are unsure if they have enough saved, or anyone who wants to reduce any risk of outliving what they have saved.

Usually advertised as tax-deferred retirement options to standard stock and bond investments like IRAs and 401(k)s, annuities are also used in structured legal settlements, survivor benefits, and even lottery distributions and casino winnings.

Although most commonly used for retirement, annuities can be used to turn a large, lump-sum payment from winning the lottery or a large payout from a lawsuit, for example, into steady cash payments. Simply put, an annuity turns your original investment into long-term payments, like a substitute for income (or, in the case of a settlement or other lump-sum payment, a second steady form of income).

Although some annuities can be distributed by the chosen insurer/financial institution for a set period of time, like 15 years, other annuities offer lifetime payments, so you don’t have to worry about outliving your annuity income.

Different Types of Annuities

If you decide to invest in an annuity for your retirement, it is best to know which one to select. How much money you want to invest, or how much risk you want to take on, can drastically change which annuity is the right option for you.

There are two main types of annuity contracts: immediate and deferred.

  • Immediate annuities allow you to start collecting payments within a year of your investment.
  • Deferred annuities keep on investing your money for a year or longer until you are ready to start collecting payments.

Besides these two types of annuity contracts, there are three main subsets of annuities: variable, fixed, and indexed.

Variable Annuities

Variable annuities enable you to invest your money in a variety of investment funds, like mutual funds. This means that your payments are based on the performance of the stocks in your annuity investment portfolio.

Variable annuities are a higher risk than fixed annuities. If the stocks you are tracking perform poorly, your annuity payment will be lower; however, if your stocks perform well and have high returns, you will also receive a higher return from your annuity income.

Fixed Annuities

Fixed annuities are a low-risk option that ensures a fixed interest rate over a given period of time and provides low investment minimums. These are best for those not looking to invest a large sum of money and looking for security with low risk.

Some fixed annuities will give you higher returns during the years that your annuity financial institution has higher returns. However, during years when the financial institution earns lower returns, you are still guaranteed the minimum fixed interest on your annuity.

Indexed Annuities

Indexed annuities are based on index funds like a mutual fund or exchange-traded fund that track the general trends of the stock market like the S&P 500. With an indexed annuity, you track gains that come about from the natural (year-to-year) increase of the stock market.

However, to protect you from extreme volatility in the stock market, most indexed annuities come with a cap in the annuity contract. This limits how much you will gain when the stock market rises. A floor or minimum is usually included to balance this out. This ensures the value of your investment if the stock market crashes, limiting your annual loss even if the index(es) you’ve chosen plummets in value.

The cap and floor included in most indexed annuities are important because, although index funds are generally considered less volatile than any single or small group of stocks, their values can still vary greatly. Therefore, this minimum ensures that your retirement income does not become obsolete during the years of potential losses for your index.

Benefits of an Annuity

Annuity benefits can vary depending on the type of annuity you are investing in, your insurance provider, and your own preferences for the contract. However, most annuity contracts include or have the option to include the following benefits:

  • Tax-deferment: Most investments are taxed yearly, but the investment earnings in annuities aren’t taxed until they are withdrawn. This means that while your funds are invested in your annuity, they are growing tax-free, which potentially leads to a higher yield.
  • Lifetime income rider: An annuity with a lifetime income rider reduces the risk of outliving your savings by making sure you have a steady income for the rest of your life. This means that even if your account balance hits zero, you will still continue to receive payments.
  • Flexible payments: Annuities allow you to choose between regular payments and cash out if you ever want to.
  • No annual contribution limit: Unlike 401(k)s and IRAs, annuities have no contribution limit. This means you can invest as little or much as you’d like.
  • Death benefits: If your annuity contract includes a death benefit rider, then your heirs will receive the leftover money from your annuity company. This ensures your beneficiaries receive a payout when you die.
  • Free-look period: Many states require annuity providers like insurance companies a free-look period, which allows an individual investing in an annuity to cancel the contract without receiving cancellation fees.

How Do Annuities Work?

Annuities are designed to supply the individual with income through accumulation and yearly payments. When you purchase a deferred annuity, you pay a premium to your insurance provider. The payment period varies depending on your contract. It is known as the accumulation phase, where your investment payments are accumulated in your annuity fund.

Once the distribution phase begins (typically when retirement begins, but depending on the terms of your contract), you will begin receiving regular payments to support you through your retirement. With immediate annuities, there is no accumulation phase. For example, you might make your investment a month before you wish to begin receiving regular payments from your annuity.

Annuity contracts move the risk of investing in the stock market (which, of course, can be volatile) to the insurance company, meaning that they are much lower risk than investing your savings directly in the stock market. Therefore, if you have an annuity contract investing in stocks that begin performing poorly, those losses burden the insurance company rather than your funds invested in an annuity. In other words, you would have a reduced risk of outliving your savings and are thereby much more secure in your retirement.

Insurance companies, in turn, charge a variety of fees to offset their risk. This includes fees related to investment management, contract riders (like the death benefit rider mentioned earlier), and other services. Surrender periods are also common, which charges hefty fees for the contract holder if they wish to withdraw money from their annuity early.

Additionally, annuity providers usually include caps that put an upper limit on your returns if your investments perform very well, along with other expenses like participation rates on indexed annuities.

Annuities vs. Life Insurance

Life insurance provides families with a lump sum of money after a life insurance holder passes, while annuities provide the contract holder with regular payments in the form of income. Although annuity contract holders may pay a premium for a death benefit rider to provide their heirs with left-over money from their annuity contract in the form of one large payment like life insurance policies, and both life insurance policies and annuities (excepting the part derived from investment income) are tax-deferred, the goals of each are very different.

An easy way to think about the biggest difference between each is to think about why you would buy either one. You buy life insurance to provide for your family after your passing, while you pay for an annuity to provide for yourself during your retirement and before you pass.

Call Peachtree Financial Solutions for Your Annuity Questions

Our team of friendly representatives at Peachtree Financial Solutions is happy to answer questions about selling your current annuity. Give us a call today at 1 (800) 370-4063 to speak with a representative!

Peachtree Financial Solutions does not sell annuity products.

The above article is intended to provide general information and should not be construed as advice of any kind. Peachtree Financial Solutions does not provide legal, financial or tax advice and is a purchaser of future payments. You should consult with independent professionals for such advice.

 

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