The Annuity: The Complete Guide

Shawn Plummer

CEO, The Annuity Expert

What is an annuity and how does it work?

What are annuities? According to the National Association of Insurance Commissioners, an annuity is defined as a contract between a consumer and an insurance company created primarily for retirement planning purposes. In exchange for a lump sum of money, the insurance company offers the investor tax-deferred growth for retirement savings plans and/or promises to regularly pay an income during retirement for either a period of time or for the rest of the owner’s life.

Can you lose your money in an annuity?

Annuities are long-term investments divided into two categories:

  • Insurance-based annuities
  • Investment-based annuities

You can not lose money to stock market volatility in insurance-based annuities. Most annuities are insurance products. Insurance-based examples include:

You can lose your money in investment-based annuity products (securities), just like stock, bonds, and mutual funds. Variable Annuities and Registered Linked Annuities are considered investment-based. Investment-based contracts include:

Who Buys Annuities?

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How Do Annuities Work?

The purchaser pays a premium to the insurance company, and in exchange, the insurance company provides a contractually bound series of funds or benefits to the policy owner. At death, the insurance company then provides the remainder of the cash value (if any) to the designated beneficiary. These are the basics explained.

Annuities are considered an actual insurance product due to the amount of risk. The insurance company is counting on the insured to live long enough so that the premium used to purchase the retirement plan along with any interest earned exceeds the policy’s death benefit.

  • Accumulation Phase: The accumulation refers to any deferred plan and is the period your retirement plan grows before you start receiving an income.
  • Distribution Phase: This refers to when a policy owner either annuitize their annuity or turns on the optional lifetime income rider to start receiving a series of payments or lifetime withdrawals from the insurance company.

The Benefits of an Annuity

Guaranteed Income: The ultimate purpose is to make sure that the investor will get a steady stream of income in retirement. Customers can purchase one of these retirement plans to supplement a paycheck during retirement as if they were still working. The customer layers the compensation on top of their Social Security check. The guaranteed income will be paid to the customer over a period of time or for the rest of their life.

Tax-Deferred Growth: Annuity contracts grow tax-deferred, which means the retirement savings plan is not taxed until a withdrawal is made, similar to an IRA, 401k, or a Pension Plan. All of these retirement plans share a common benefit, which is tax deferral. Tax deferral simply is a tax advantage from the IRS, which is delaying paying the tax until the retirement plan owner withdraws money for income purposes. Once a withdraw is made, the income is subject to ordinary income tax.

Long Term Care Insurance: Insurance companies have developed benefits and riders to help offset the ever-increasing cost of long-term care. A few companies have even created deferred annuities to offer tax-free benefits to pay for nursing homes, assisted living facilities, and home healthcare.

The Annuity Contract

There are three parts to an annuity contract, which are the contract owner, annuitant, and beneficiary.

  • Contract Owner: The contract owner is the owner of the annuity. The owner is funding the annuity, can change the beneficiary, make withdrawals, pay the premiums, surrender the contract, and make any changes to the contract before annuitizing the contract. The contract owner can be a person or an entity such as a trust or charity.
  • The Annuitant: The annuitant is insured and has to be a person, not an entity. The annuitant can be different than the contract owner, but in most cases, both are the same. Any payments are based on the annuitant’s life expectancy.
  • The Beneficiary: The beneficiary is the designated recipient of the annuity’s death benefit. The beneficiary can be either a person or an entity.

Contract Types

  • Deferred Annuity Contracts: A deferred contract is a vehicle for accumulating money (cash value) with the option of converting retirement savings into a source of guaranteed income for life. Deferred annuities will grow on a tax-deferred basis, just like a 401k or IRA.
    • This means you don’t have to pay ordinary income taxes on annual earnings like other savings plans such as a Certificate of Deposit (CD). Instead, you pay the income taxes as you withdraw income from the tax-deferred annuity.
  • Immediate Annuity Contracts: Single-premium immediate contracts are precisely the opposite of deferred contracts in that the contract owner is converting their original investment immediately (within the first 12 months) into a guaranteed series of income paychecks. The SPIA is built strictly for taking a lump-sum payment of money, giving the money to the insurance company, and generating a source of income for you.
    • A common problem for pre-retirees is figuring out how to convert their long-saved retirement accounts into a monthly paycheck to live on and maintain that income for the rest of their lives.
  • Single-Premium Deferred Annuities: Single-premium products are tax-deferred contracts that allow a one-time initial investment into a contract with no option to add additional funds to the existing policy. This means once you purchase a contract with a single payment, you can’t add more money to that contract. Instead, you will have to start a new contract for additional funds.
  • Flexible-Premium Deferred Annuities: Flexible-premium annuities are tax-deferred contracts that allow an owner to contribute additional funds to an existing policy during the contract’s accumulation period. If funds are added to a flexible-premium deferred annuity, the insurance company typically invests the added funds in a fixed account until the following anniversary or reset period.

Annuities Vs. Life Insurance

Annuities are not life insurance. In fact, annuities are the exact opposite of life insurance. A life insurance policy’s primary function is to create an estate for beneficiaries by periodically paying into a contract. An annuity’s primary function in terms of an estate is to liquidate an estate quicker by avoiding probate.

Another key difference between annuities and life insurance is designed to protect against premature death. At the same time, annuities are designed to protect against the risk of living too long and running out of money.

Annuities are insurance for retirement. Life insurance is insurance for death.

Is an annuity a good investment?

Variable
Annuity
Fixed Index
Annuity
Fixed
Annuity
Immediate
Annuity
Deferred
Income
Annuity
Buffer
Annuity
Principal ProtectionNoYesYesYesYesNo
Access To PrincipalYesYesYesNoNoYes
Control Over MoneyYesYesYesNoNoYes
Tax-Deferred GrowthYesYesYesNoNoYes
Guaranteed GrowthNoYesYesNoNoNo
Guaranteed IncomeYesYesYesYesYesYes
Inflation ProtectionYesYesNoYesYesYes
Death BenefitYesYesYesYes/NoYes/NoYes
Long-Term Care HelpYesYesYesNoNoYes

With any retirement plan, there is risk and rewards. Risks and benefits include:

The Pros of Annuities

  • Annuities are the only retirement plan that guarantees an income for the rest of your life.
  • Various annuities can help pay for long-term care expenses such as a nursing home, assisted living, home health care, and adult daycare.
  • Annuities can offer an enhanced death benefit with no underwriting that may avoid probate.
  • Some policy owners can grow their retirement savings faster with tax-deferred growth and triple compounding.
  • Fixed annuities and Multi-Year Guaranteed Annuities (MYGA) offer a higher rate than a CD, and taxes are not paid annually.
  • Either annuitization or a lifetime income rider can often help with inflation with the Cost of Living Adjustments.
  • Most deferred annuities (except variable annuities) offer peace of mind in that customers won’t lose their money to stock market downturns.
  • Fees can be minimal if any at all.
  • With most deferred products, clients get to “lock-in” their gains vs. the market’s ups and downs of financial planning.

The Cons of Annuities

  • In most cases, retirement annuities are long-term investments between you and the insurance company. The shortest contract currently is two years in length.
  • If a policy owner (annuitant) chooses to annuitize their contract, there is no turning the annuitization off. You are stuck. This is a huge disadvantage. The good news you can add a lifetime income rider instead!
  • There is limited liquidity in most cases, meaning while you’re growing your retirement plan, you may only have access to 10% of the contract’s value each year until the contract is expired.
  • Some would say you could earn more money in the market over the long term. This is very true depending on where you’re currently at in your career timeline.
  • Risks also include losing money due to stock market volatility in a variable or registered-index linked annuity.
  • Annuities are not FDIC insured and backed by the ability of the issuing insurance company. Luckily, every insurance company has a State Guaranty Association to back the insurance company in case of solvency.

Types of Annuities

Did you know there are 13 different types of annuities today? Let’s check out the options for retirement.

  • Here we’ll briefly go over the 13 types of annuities.
  • Each has its pros and cons.
  • Each serves a specific purpose.
  • Not all annuities are created equal.

There are two main categories of annuities:

  1. Insurance-based: You can not lose money to stock market volatility.
  2. Investment-based: You can lose money to stock market volatilty.
Can Not Lose MoneyCan Lose Money
Immediate AnnuityVariable Annuity
Fixed AnnuityBuffer Annuities
Fixed Index Annuity
Long-Term Care Annuity
Longevity Annuity
QLAC
Medicaid Annuity

Within these two categories, there are two subcategories:

  1. Immediate Contracts
  2. Deferred Contracts
ImmediateDeferred
Immediate Annuities (SPIA)Fixed Annuities
Medicaid AnnuitiesFixed Index Annuities
Charitable Gift AnnuitiesVariable Annuities
Lottery PayoutBuffer Annuities
Pension PayoutsLong-Term Care Annuities
QLAC
Deferred Income Annuities

Annuity Types

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  • Immediate Annuity: A SPIA is a contract (with no cash value). A contract owner exchanges a lump sum of money with an insurance company for an immediate, irrevocable series of retirement income payments that are guaranteed for the contract’s specified period. Lottery payments are an example of an immediate annuity.
  • Variable Annuity: A variable annuity is a tax-deferred investment product for retirement planning that allows you to participate in investments, including stocks, bonds, and mutual funds. You get all the upside and the downside potential with a variable product.
    • Variable annuities offer greater risk than other product types. You must seek a financial professional to find the best tax-sheltered investment options.
  • Fixed Indexed Annuity: An indexed annuity is a retirement plan that allows you to participate in a portion of the stock market’s positive performance while providing principal protection from volatile market conditions at the same time. 
    • Your tax-sheltered retirement accounts get the opportunity to earn market gains with no downside potential and tax deferral.
  • Fixed Annuity: A deferred fixed annuity is a tax-deferred insurance product for retirement planning that provides a fixed guaranteed interest for the contract term, similar to a Certificate of Deposit (CD).  
    • Your retirement savings earn a fixed, guaranteed amount of interest annually for a fixed period of time. Sometimes called a “CD annuity.”
  • Long Term Care Annuity: A Long Term Care Annuity is a tax-deferred fixed contract that provides an enhanced tax-free benefit to supplement qualified long-term care services and facilities.
  • Deferred Income Annuity: The Deferred Income Annuity (DIA) is an income contract similar to a pension. A consumer exchanges a lump sum of money upfront today for a deferred, irrevocable retirement income stream (over a fixed period of time or lifetime) in the future.
  • Two-Tiered Annuity: A two-tier annuity is a tax-deferred fixed indexed contract where you invest money upfront, grow your investment during the accumulation period, and annuitize your future contract values into an irrevocable guaranteed income stream. Annuitization is required.
  • Qualified Longevity Annuity Contract (QLAC): A QLAC is a Deferred Income Annuity (DIA) funded specifically by qualified retirement savings plans to defer Required Minimum Distributions (RMD).
  • Structured Settlement: A Structured Settlement is a structured, irrevocable series of periodic payments from an insurance company commonly court-ordered similar to an immediate annuity.
  • Secondary Market Annuity: A secondary market annuity is the reselling of an annuitized distribution (guaranteed income stream payments) in exchange for a lump sum now.
  • Medicaid Annuity: A MCA is a unique SPIA meant to financially maintain a healthy elderly spouse’s lifestyle while their unhealthy spouse receives Medicaid.
  • Charitable Gift Annuity: A charitable gift annuity is a transfer by a donor to a charitable organization. In return, the donor receives monthly payments. If the annuity’s actuarial value is less than the value of the donation, then the difference in value is declared a charitable deduction for federal tax purposes. The annuity payments to the donor are tax-free partial returns based on actuarial tables of life expectancy.
  • Registered Index-Linked Annuity: The Buffer Annuity is a hybrid of the fixed indexed and variable annuity. When an index performance is positive, the plan may earn interest, limited by a cap or participation rate. If the index performance declines, the retirement plan will earn zero interest and can lose value up to a “floor.”

Annuity Myths

  • Hidden fees – Depending on the type of product you purchase, your policy could have no charges. With that said, annuities do enforce surrender charges on withdrawals greater than your free allowance during the surrender period. Some products have administrative fees and additional fees for optional riders and benefits, enhancing your policy and providing more benefits.
  • Annuities are complicated. – These retirement plans are fairly simple, with a plethora of options to add on. The main 2 components are the base contract itself and the optional income benefit that provides you an income similar to a pension or Social Security Benefits.
  • I can lose money. – Unless you have a Variable or Registered Linked Annuity, you can not lose money to market volatility.
  • No liquidity. – Most deferred annuities allow for penalty-free withdrawals, systematic withdrawals, and waivers to assist in health-related issues such as terminal illness, nursing homes, or home health care. If you annuitize your contract or purchase an income annuity, you do lose control over your money.
  • No death benefit. – Insurance companies typically waive surrender charges at death if the plan has not been annuitized. Any remaining account value is passed down to the beneficiaries and typically avoids probate. Probate is a judicial process to establish the validity of a will. Assets in an estate typically cannot be passed down to the beneficiaries until the probate court has established the will’s validity and authorized the executor to distribute them. Probate can be lengthy and expensive.
  • Pay fees to buy an annuity. – Typically, you are not required to pay a fee to a financial professional such as an insurance agent, financial advisors, or RIA to purchase a policy. They are compensated through a commission from the insurance company. If your financial professional charges you both a fee and collects a commission specifically from an annuity sale, find another advisor. Insurance companies build the commission into the plan when designing the product.

Riders and Benefits

What is an annuity rider? A rider is a benefit that is typically added onto the retirement plan to serve a specific purpose like lifetime income, estate planning, extra liquidity, and long-term care planning.

Annuities provide a number of benefits. While the income benefit (annuitize or income rider) is the primary one, the other benefits explained below are also important.

  • Income Rider: An Income Rider or Guaranteed Lifetime Withdrawal Benefit is an optional benefit or “add on” that distributes a steady stream of retirement income for life for the remainder of the owner’s and/or owner and spouse’s lifetime. Income riders typically come at an additional cost. Use our annuity calculator to get a quote.
  • Enhanced Death Benefit Rider: Some annuities offer an Enhanced Death Benefit is a benefit that delivers a greater death benefit than the Accumulation Value to the policyholder’s heirs. Enhanced death benefits are often used as an alternative to life insurance. This life insurance alternative requires no medical underwriting, typically.
  • Return of Premium: Return of Premium is a feature in which a contract owner can terminate their current contract at any given time and receive their original investment back (minus fees and withdrawals). 
  • Accumulated Penalty-Free Withdrawals: Accumulated Penalty-Free Withdrawals are unused penalty-free withdrawals that can roll over to the following year, increasing the client’s penalty-free liquidity until withdrawn. 
  • Nursing Home Waiver: The waiver of surrender charges if a client is admitted to a qualified nursing home facility.
  • Terminal Illness Waiver: The waiver of surrender charges if a client is diagnosed terminally ill not expected to live more than 12 months.
  • Cost of Living Adjustment (COLA): A Cost of Living Adjustment is a feature on an income rider that increases the owner’s income payment to help with inflation.
  • Spousal Continuation: Spousal continuation is a standard provision for a surviving spouse upon death to continue the deceased’s contract for at least the remainder of the initial term. Most deferred contracts offer this as a death benefit option.

How to Find an Annuity Death Benefit

Beneficiaries can find death benefits on the deceased’s annuities by contacting the National Association of Insurance Commissioners (NAIC). A death certificate from the funeral home that conducted the burial or cremation would improve the NAIC’s search for any forgotten life insurance policies. The policy locator service is free with no limitations, and the process could take up to 90 business days. Be prepared to have as much personal info on the deceased as possible.

Conclusion

Now we’ve gone over the various types of products, and it becomes a matter of which is the best plan for you.

  • Income Annuities can offer the highest income payments but have the least flexible contracts.
  • Fixed Annuities are the most conservative product type in which you receive a fixed interest rate for a fixed period of time.
  • Fixed Indexed Annuities are the most moderate product types in which you get to participate in some of the market upside potentials but have all the downside protection from market risk and provides a retirement income for life.
  • Variable Annuities are the most aggressive product type in which you can participate in all of the markets’ upside and downside. You should seek an investment professional before purchasing a variable product.

Try to find an issuing insurance company with a high rating and financial strength. We can help you.

Shawn Plummer

CEO, The Annuity Expert

I’ve sold annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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