What Is an Annuity and How Does it Work?

When an average layperson hears the word “annuity” for the first time, a confused expression more than likely forms on his or her face, and rightfully so, since it sounds like a technical term only utilized in professional circles. 

For the most part, it is. An annuity is often used when an insurance agent explains it to retirees as a viable option that aids in income management upon retirement and also handles the risk of outlasting their savings.

What are Annuities?

Simply put, an annuity is an insurance contract issued by a particular financial institution that allows the insurer to make payments to you, the annuitant. It intends to pay invested funds to you in a guaranteed and fixed income stream whenever you decide to retire. The payout will be given either as a series of payments or as one lump sum.

What are Other Reasons to Purchase Annuities?

Besides the main reason mentioned above, there are other provisions:

• As a death benefit – When the annuitant dies before the start of receiving payments, the person named as a beneficiary will receive a specific payment.
• As recurring payments for a particular amount of time – It can happen for the entire remaining lifetime, or the spouse or a designated person.
• As tax-deferred growth – The annuitant does not pay taxes on the investment gains and income from the annuity until the money is withdrawn. 

What are the Different Types of Annuities?

There are three kinds of annuities:

1. Fixed annuity – The insurance provider will promise annuitants a minimum interest rate and periodic payments in a fixed amount. The fixed annuity is strictly regulated by state insurance commissioners, which you should check in your particular state for benefits and risks. This is done to confirm that the insurance provider you are interested in is registered in your state to sell insurance. 
2. Variable annuity – The insurance provider will allow annuitants to direct their annuity payments to various investment alternatives, which usually are mutual funds. Payouts will deviate depending on the amount put in, expenses, and investment returns. The Securities and Exchange Commission (SEC) regulates variable annuities. 
3. Indexed annuity – An indexed annuity combines the attributes of insurance products and securities. The insurance provider will credit you with returns based on a stock market index, similar to Poor’s 500 and Standard. State insurance commissioners regulate Indexed annuities. 

How Do Annuities Work?

The most basic thing about an annuity is that it works by converting an insurance premium into a stream of payments. The duration of the payments and amount will depend on different factors like the premium amount, annuity type, the selected payout alternative, and the age of the annuitant. 

Annuities are not short-term investment strategies and can be optimized for long-term growth or a particular income. Most types provide income through an annuitization and accumulation process. One exception is an immediate annuity (payout is straightaway) that will start paying out early within a month of purchase without an accumulation phase needed. 

If you prefer a deferred annuity (payout at a later date), you will pay a premium to an insurance company. Throughout the accumulation phase, the initial investment will increase tax-deferred, generally from five to thirty years based on the term of the contract. During the distribution (annuitization) phase begins, you will begin receiving regular payments, based on the contract terms. 

Your annuity contract transfers the risks of a down market to the insurance provider, which makes you, the annuitant, protected from market and longevity risk. To offset the risk, your insurance provider will charge fees for administrative services, contract riders, and investment management. Additionally, most annuity contracts include surrender periods, which means you cannot withdraw money from the annuity without obtaining a surrender fee.

Moreover, insurance providers typically impose spreads, caps, and participation fees on indexed annuities that each can reduce returns. 

Different Annuity Phases

When you have selected a particular annuity ideal for you, it goes through various periods and phases:

• Accumulation phase – It is the period before the payout begins and your annuity is funded, and during this stage, the money you’ve invested grows on a tax-deferred basis. 
• Annuitization phase – It will happen once payments begin.

What Are Other Features of Annuities?

• As annuity riders (A provision you can include to your annuity contract to make sure you will meet your financial needs) 
• As commissions and fees
• As death benefits
• As living benefits
• Taxation
• Free lock period

Various Annuity Fees and Charges

• Annuity fee – This fee varies generally due to the type of annuity and the insurance provider. Most don’t charge an annual fee but include commissions in the contract.
• Annuity surrender charge – A deferred annuity usually has a surrender charge. It is similar to an early withdrawal penalty on a certificate of deposit, and each annuity contract has a different surrender period, ranging from two to ten years.
• Variable annuity fee – This type is included in the most complex contracts and requires the insurance provider to manage multiple subcontracts that are invested in the annuity premium. Common variable fees are administrative fees, mortality and expense risk charge, penalties, underlying fund expenses, rider fees, and charges.

What are the Benefits of Annuities?

• It enables the investor to save money without paying taxes on the interest until later.
• It creates a steady income stream upon retirement.

Conclusion

Are annuities good investments? To determine this, you have to think about your personal investment needs and goals. Furthermore, you should consider your age, lifestyle, and risk tolerance. This way, you would get the best annuity for you.

Email us at sales@ascend99.com if you’re interested.