What Is an Annuity? How Annuities Work and the Main Types

What is an annuity? At its most basic, it is a contract with an insurance company. You put money into the contract, and the company agrees to provide the benefits described in its terms. Depending on the annuity, those benefits may include income, credited interest, protection from certain market losses, or other guarantees.

The definition is fairly simple. The contracts are not. The word annuity covers products that can work very differently, which is why comparing rates or product names too early can lead you in the wrong direction.

My view is that the retirement need should come first. What do you need this money to do? If the answer is not clear, you are not ready to compare annuities. An annuity can be one tool within a retirement plan, but it is not a retirement plan by itself.

Prefer to Listen or Watch?

This article was adapted from Episodes 115 and 116 of The Simply Retirement Podcast. If you would rather listen to or watch the conversations:

Episode 115: Listen to or watch Understanding Annuities Before You Decide

Episode 116: Listen to or watch Which Type of Annuity Fits Your Retirement Plan?

What Does an Annuity Do?

The most common retirement use is to help turn savings into income. An annuity may provide payments for a set period or for life. It may also let money grow before payments begin. The result depends on the type of annuity and the choices written into the contract.

That can be useful when Social Security, a pension, and other reliable income do not fully support your planned spending. Still, an annuity is only one way to create retirement income. Investment withdrawals, cash reserves, bonds, rental income, and other resources may also play a role.

The planning question is whether an annuity fills a need that the rest of your plan does not already cover.

The Two Common Phases of an Annuity

Many annuities have an accumulation phase followed by an income phase. Understanding the difference makes the contract easier to follow.

The accumulation phase

During the accumulation phase, your money remains in the contract before income begins. Depending on the annuity, it may earn a stated interest rate, receive interest tied to a market index, or be invested in market-based options called subaccounts.

The income or payout phase

During the income phase, the contract begins making payments. Some contracts start soon after purchase. Others may wait for years.

You may also hear the word annuitization. Annuitizing generally means exchanging some or all of the contract value for a stream of payments. Not every owner formally annuitizes. Some contracts allow withdrawals or provide income through a rider instead. That choice can affect your access to the money, costs, guarantees, and taxes.

Do You Need Income Now or Later?

A practical way to narrow the choices is to decide when you want the income to begin.

Immediate income annuity

An immediate income annuity is designed for payments to begin soon. You generally give the insurance company a lump sum. In return, it makes payments based on the option you select.

Payments may continue for your lifetime, for the joint lives of you and a spouse, or for a stated number of years. The amount depends on factors that include how much you contribute, your age, current interest rates, and the guarantees you choose.

The main trade-off is access to the money. Once you exchange the lump sum for income, you may have limited or no ability to take the original amount back. That may be reasonable when dependable income is the priority, but you should understand the restriction before you commit.

Deferred income annuity

A deferred income annuity also focuses on income, but the payments begin at a future date. You might purchase the contract today and schedule income to begin several years later.

Waiting longer may produce a larger future payment, in part because the insurance company expects to make payments for fewer years. You may give up flexibility and access to the money while you wait. The start date should match when you expect to need the income.

How Should the Money Work While You Wait?

If income will not begin right away, consider how you want the money to work during the accumulation phase. That points you toward the contract's basic structure.

Fixed annuity

A fixed annuity credits a stated interest rate for a period set by the contract. Its main appeal is predictability. You know the rate the insurance company has agreed to credit during that period, subject to the contract terms.

A fixed annuity is sometimes compared with a certificate of deposit, but they are not the same. A CD is a bank product that may receive FDIC insurance within applicable limits. A fixed annuity is an insurance contract. Its guarantees depend on the issuing insurance company's ability to meet its obligations.

Fixed indexed annuity

A fixed indexed annuity credits interest using the performance of a market index, such as the S&P 500. Your money is not invested directly in that index. The insurance company uses a formula that may include a cap, participation rate, or spread to calculate the interest credited to the contract.

When the index rises, you may receive only part of that gain. When it declines, the contract may credit zero interest for that period rather than pass along a direct market loss. That does not remove every risk or cost. Withdrawals, surrender charges, rider fees, and other contract terms can still reduce what you receive.

A registered index-linked annuity, sometimes called a buffer annuity, works differently. It may absorb a stated amount of an index loss, but you can lose money beyond that buffer. Make sure you know which product is being discussed.

Variable annuity

A variable annuity allows you to place money in investment options called subaccounts. These may look similar to mutual fund choices in a retirement plan. The contract value can rise or fall based on how those investments perform.

A variable annuity may appeal to someone seeking tax-deferred growth who is willing to accept market risk. The contract may also offer optional income or death benefit riders. Those features can add costs, so review the full fee structure before deciding whether the benefit is worth it.

What Is Actually Guaranteed?

The word guaranteed comes up often in annuity conversations, but it does not mean the same thing in every contract. An annuity might guarantee a stated interest rate, a minimum account value, a future income amount, or a death benefit. It may not guarantee all of them.

Every guarantee is based on the contract and the claims-paying ability of the issuing insurance company. Variable investment options can still lose value. Indexed products may limit gains, and optional riders can carry their own rules and costs.

Do not stop at the word guaranteed. Ask exactly what is guaranteed, how long it lasts, and what conditions apply.

How to Begin Comparing Annuities

Before comparing rates or product names, answer a few planning questions:

What retirement need am I trying to address?

Do I need income now, later, or perhaps not at all?

How much access to this money might I need?

What market risk am I willing to accept?

What benefit or guarantee is most important to me?

What am I giving up in exchange for that benefit?

What other strategies could address the same retirement need?

These questions will not tell you which annuity to buy. They will tell you whether an annuity deserves a place in the conversation at all.

Frequently Asked Questions About Annuities

Do all annuities provide guaranteed lifetime income?

No. Some annuities are designed mainly for accumulation. Others offer lifetime income through annuitization or an optional rider. The contract explains what income is available and what conditions apply.

Can you lose money in an annuity?

It depends on the type and how you use the contract. Variable annuities and registered index-linked annuities can lose value because of market performance. Surrender charges, withdrawals, and fees may also reduce what you receive from other annuity types.

Are annuities tax-deferred?

Earnings inside a nonqualified annuity generally grow tax-deferred until money is withdrawn. An annuity held inside an IRA does not create an additional layer of tax deferral because the IRA is already tax-deferred. The source of the money and the way you receive it can affect taxation. We will address those rules in a separate article adapted from Episode 118.

Is an annuity right for retirement?

An annuity may fit when it addresses a clear retirement need and the benefits are worth the trade-offs. It may be a poor fit if you need the money soon or cannot clearly explain what the contract provides and costs. I would also compare it with simpler ways to solve the same problem.

Start With the Retirement Need

I do not think an annuity is automatically good or bad. The answer depends on the job you expect it to do and the trade-offs you are willing to accept.

An annuity may be worth evaluating when you need dependable income, principal protection, tax deferral outside a retirement account, or a specific contract guarantee. If you cannot clearly explain the need it is meant to address, it is too early to compare products.

Owning an annuity is not the goal. The goal is a retirement plan that supports the life you want to live.

Does an Annuity Fit Within Your Financial Plan?

Our free checklist can help you organize the questions to consider before purchasing an annuity or reviewing one you already own. Download Does an Annuity Fit Within My Financial Plan?

If you would like to see how retirement income, investments, taxes, and other decisions work together in your situation, learn more about the Simply Retirement Roadmap™.

Disclosure

Annuities are insurance products issued by insurance companies and involve costs, fees, limitations, and contractual terms that vary by product. Guarantees are backed solely by the claims-paying ability of the issuing insurance company. Before purchasing an annuity, investors should carefully consider their financial objectives, risks, charges, expenses, and contract features, and consult with their financial, tax, and legal professionals.

Content here is for illustrative purposes and general information only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy.

Information here is provided, in part, by third-party sources. These sources are generally deemed to be reliable; however, neither Blake Wealth Management nor RFG Advisory guarantee the accuracy of third-party sources. The views expressed here are those of Blake Wealth Management. They do not necessarily represent those of RFG Advisory, their employees, or their clients.

This commentary should not be regarded as a description of advisory services provided by Blake Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.