What Is An Annuity? The Complete Guide To Understanding Annuities

Shawn Plummer

CEO, The Annuity Expert

An annuity is a financial product that helps with retirement planning. Annuities work in many different ways and can benefit just about every retiree, especially those who want to ensure a steady income stream in retirement. There are many kinds of annuities available, so it’s essential to do your research before deciding if this type of investment is right for you. This comprehensive guide will discuss the basics of annuities and why they might be a good fit for your retirement portfolio.

What is an annuity?

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. The insurance company offers the investor tax-deferred growth for retirement savings plans in exchange for a lump sum of money. Insurance companies also promise to regularly pay an income during retirement for either a set period of time or for the rest of the owner’s life.

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Can you lose your money in an annuity?

Annuities are long-term investments divided into two categories:

  • Insurance-based annuities
  • Investment-based annuities

First, your principal amount can not lose money to stock market volatility in insurance-based annuities. Most annuities are insurance products, and insurance protects against market risk. Insurance-based examples include:

  • Traditional Fixed or an MYGA
  • Fixed Indexed Annuities (Equity Indexed Annuities)
  • Long Term Care Annuities
  • Single-Premium Immediate Annuities (SPIA)
  • Deferred Income and Longevity Annuities
  • Qualifying Longevity Annuity Contract (QLAC)

Investing involves risk. Your principal can lose money in investment-based annuity products (securities), just like investing in stocks, bonds, and mutual funds. Variable Annuities and Registered Linked Annuities are sold by a licensed financial advisor and are considered investment-based and regulated by the Securities and Exchange Commission (SEC). Investment-based contracts include:

  • Variable annuities
  • Buffer annuities
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Who Buys Annuities?

The following video explains why a consumer will purchase an annuity contract.

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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 annuity company is counting on the insured to live long enough (longevity risk) 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 phase refers to the period your annuity grows before paying you a retirement income.
  • Distribution Phase: The annuity definition explains the accumulated money is converted into a series of payments for life or a fixed number of years. This payout phase refers to when the policy owner begins to receive payments or lifetime withdrawals from the annuity company.

The Primary Benefits of an Annuity

The primary investment objective of annuities is to provide guaranteed income to retirees and to accumulate funds that will provide future income payments for pre-retirees. The three primary benefits of annuity insurance are:

Provide Guaranteed Income: The ultimate purpose is to secure a financial future to ensure the investor will get a steady stream of income in retirement. Customers can purchase one of these retirement vehicles to supplement a paycheck during retirement as if they were still working to fund day-to-day living expenses. The customer layers the compensation on top of their Social Security check. The guaranteed retirement income will be paid to the customer over a set period of time or for the rest of their life. Inflation protection is also available.

Tax-Deferred Growth: Annuity investments 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. These retirement plans share a common tax treatment, which is tax deferral. Tax deferral is a tax advantage from the Internal Revenue Service (IRS), delaying paying the tax on investment gains until the owner withdraws money for income purposes. Once an owner receives payments, the guaranteed stream of annuity income is subject to ordinary income tax. Tax implications are enforced like IRA and 401(k) plans if retirement income is withdrawn too early.

Long Term Care Insurance: Other investment objectives include paying for LTC. 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.

How An Annuity Contract Is Structured

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

  • Owner: The contract owner is the owner of the annuity. The owner can purchase and fund annuities, can change the beneficiary, withdraw money, pay the premiums, surrender the contract, and make any changes to the contract before annuitizing the insurance contract. The contract owner can be a person or an entity such as a trust or charity.
  • 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 lifetime payments are based on the annuitant’s life expectancy.
  • Beneficiary: The beneficiary is the designated recipient of the annuity’s proceeds. 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.
    • A tax-deferred basis 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 deferred annuity.
  • Immediate Annuity Contracts: Immediate contracts are precisely the opposite of deferred contracts. 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 reliable income for you.
    • A common problem for pre-retirees is figuring out how to convert their long-saved retirement accounts (401k or IRA) into a monthly paycheck to live on and maintain that guaranteed income for the rest of their lives.
  • Single-Premium Deferred Annuities: These products are tax-deferred retirement accounts 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 Policies

Annuities are not life insurance. 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 critical difference between annuities and life insurance is designed to protect against premature death. At the same time, annuities are designed to protect against longevity risk and running out of money.

Annuities are insurance policies for retirement. Life insurance is an insurance policy for death.

Is leaving money to your loved ones a high priority? If so, consider life insurance products. In some cases, you don’t have to take a medical exam. Shop life insurance quotes and see if it makes sense for you. Coverage starts as low as $9.37 a month.

Is an annuity a good investment?

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

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
LTC HelpYesYesYesNoNoYes

The Pros of Annuities

  • Annuities are insurance-based retirement plan that guarantees a fixed income for the rest of your life. Consumers can feel relief that the guaranteed amount of income will never run out in retirement.
  • Consumers can plan their financial future today and determine how much money needs to be saved to generate a fixed amount of income in the future.
  • Different annuities can help pay for LTC expenses such as a nursing home, assisted living, home health care, and adult daycare later.
  • Annuities can offer an enhanced death benefit with no underwriting that may avoid probate. The beneficiary receives either the standard or enhanced death benefit.
  • Some policy owners can grow their retirement savings faster with tax-deferred growth and triple compounding.
  • Fixed deferred annuities and Multi-Year Guaranteed Annuities (MYGA) offer higher fixed interest rates than a CD, and taxes are not paid annually.
  • Either annuitization or a guaranteed 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 market downturns, and their principal is protected at the guaranteed minimum in such cases as a stock market crash.
  • 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.
  • One common advantage of a long-term investment is that you have time to ride out the ups and downs of the market. This is especially true with an annuity since the payments are spread out over a long period of time. Another advantage of an annuity is that it can provide a source of income that you can’t outlive. If you choose an annuity with a long time horizon, it can be a great way to build your wealth and secure your financial future.

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. Investors with short-term goals are not a good fit if they want their cash today or near future.
  • If a policy owner (annuitant) chooses to annuitize their annuity at retirement and start receiving payments, there is no turning the stream of income off. This is a huge disadvantage. The good news is you can add a lifetime income rider instead!
  • There is limited liquidity in most cases, meaning while you’re growing your retirement account, you may only have access to 10% of the contract value each year until the contract is expired.
  • Some would say you could earn more money in the market over the longer time horizons. This is very true, depending on where you’re currently at in your career timeline.
  • Investment strategy risks include losing money due to stock market volatility in variable or registered-index linked annuity contracts.
  • Annuities are not insured by the FDIC or any federal government agency but are backed by the claims-paying ability of the issuing insurance company. Luckily, every insurance company has a State Guaranty Association to back the provider in case of insolvency.

The Different Types of Annuities

Annuities come in many forms. Did you know there are 13 different types of annuities today? Before you purchase an annuity, do your research. So let’s check out the options for retirement.

  • Here we’ll briefly go over each type of annuity.
  • Each has its pros and cons depending on your financial situation.
  • Each serves a specific purpose.
  • Not all annuities are created equal.

There are two main categories of annuities:

  1. Insurance products: No stock market volatility risk.
  2. Investment products: Stock market volatility risk.
No-RiskAt-Risk
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

Which Plan Is Best For Me?

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  • Immediate Annuity: Immediate annuities (SPIA) is a contract (with no cash value) that will be paying retirement income immediately. A contract owner exchanges a lump sum of money with an insurance company for an immediate stream 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 an investment product for retirement planning that allows you to participate in investments, including stocks, bonds, and a mutual fund. You get all the upside and the downside potential with variable investment products.
    • Variable annuities offer greater risk than other contract types. You must seek a financial professional to determine your risk tolerance to find the best tax-sheltered investment options.
  • Fixed Indexed Annuity: An indexed annuity is a type of fixed annuity for retirement 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. Also known as a fixed, variable annuity.
  • Fixed Annuity: Fixed annuities is an insurance policy for retirement planning that provides a fixed rate of interest for a specific period of time, similar to a Certificate of Deposit (CD).  
    • Your retirement savings earn a guaranteed rate of interest annually for a fixed period of time. Sometimes called a “CD annuity.”
  • Long Term Care Annuity: A LTC Annuity is an insurance policy, typically fixed annuities, that provide an enhanced tax-free benefit to supplement future payments to pay for qualified services and facilities.
  • Deferred Income Annuity: The Deferred Income Annuity (DIA) is a fixed income contract similar to a pension. A consumer exchanges a lump sum of money upfront today for future payments. The stream of income is irrevocable and can be distributed over a period of time or for life.
  • Two-Tiered Annuity: A two-tier annuity is a fixed indexed contract where you invest money upfront, grow your investment during the accumulation period, and annuitize your future contract values into an irrevocable fixed income stream. Annuitization is required.
  • Qualified Longevity Annuity Contract (QLAC): A QLAC is a Deferred Income Annuity (DIA) with tax advantages that defer Required Minimum Distributions (RMD) on qualified retirement savings plans.
  • 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 (fixed income stream payments) in exchange for a lump sum now.
  • Medicaid Annuity: A MCA is a unique annuity contract that distributes an immediate stream of income 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 type of annuity where that transfers by a donor to a charitable organization. In return, the donor receives monthly payments for retirement income purposes. 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. The income stream is not guaranteed and not backed by the financial strength of an insurance company or a federal government agency.
  • Registered Index-Linked Annuity: The Buffer Annuity is a type of annuity that is a hybrid of fixed indexed and variable annuities. When a market index performance is positive, the plan may earn interest, limited by a cap or participation rate. If the stock market index performance declines, the retirement plan will earn zero interest and can lose value up to a “floor.”

Debunking 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 charge period. Some products have administrative fees and additional fees for optional riders and benefits, enhancing your policy and providing more benefits.
  • Annuities are complicated. – There are many types of annuities. For the most part, these retirement plans are fairly simple, with a plethora of options to add on. The main two components are the base contract itself and the optional lifetime income benefit that provides you a fixed income similar to a pension or Social Security Benefits.
  • I can lose money. – Unless you have a Variable or Registered Linked Annuity, your money is not at risk of stock market volatility.
  • No liquidity. – Most deferred annuities allow for penalty-free withdrawals (after one year), 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 initial investment.
  • No money for beneficiaries. – Insurance companies typically waive a surrender charge at death if the plan has not been annuitized. Loved ones will receive the remaining account value 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 purchase an annuity. – Typically, you are not required to pay a fee to a financial professional such as an insurance agent, financial advisor, or RIA to purchase a policy. Brokerage services are compensated through a commission from the insurance company when selling annuities. If your financial professional charges you both a fee and collects a commission specifically from an annuity sale, find another advisor. Retirement annuity providers build the commission into the plan when their actuaries design the product.

Annuity Riders and Enhanced Benefits

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

Annuities provide several benefits. While the guaranteed lifetime income benefit (annuitize or income rider) is the primary one, the other benefits explained below are significant.

  • 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. Guaranteed income riders typically come at an additional cost. Use our annuity calculator to get a quote. The guaranteed income can be turned on or off.
  • Enhanced Death Benefit Rider: Some annuities offer an enhanced benefit that delivers a greater inheritance 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 without surrender charges at any given time during the surrender period 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 during the surrender period if a client is admitted to a qualified nursing home facility.
  • Terminal Illness Waiver: Waive a surrender charge during the surrender period if a client is diagnosed terminally ill and 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 dollar amount to help with inflation. Imagine receiving a stream of income that increases throughout retirement.
  • 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 instead of receiving the account value in a lump sum. Most deferred contracts offer this as an 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 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 or account information on the deceased as possible.

Conclusion

Now we’ve gone over the various types of annuities available, and it becomes a matter of which is the best plan for you depending on your financial goals.

  • Income Annuities can offer the highest income payments but have the least flexible insurance contracts. Once the company will begin paying money to the policy owner, the annuity payments will not stop.
  • Fixed Annuities are the most conservative financial product type in which you receive a fixed interest rate for a set period of time.
  • Fixed Indexed Annuities are the most moderate product types in which you get to participate in a portion of the market upside potentials but have all the downside protection from market risk and provide regular payments for life. The variable rate of return is typically higher than fixed annuities. Owners can earn a fixed rate as well.
  • Variable Annuities are the most aggressive contract type in which you can participate in all of the market fluctuations. 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 meet your long-term goals based on the information provided. In addition, The Annuity Expert will recommend products based on your hyper-specific needs. Request a quote from our brokerage services. We offer the largest selection of products available.

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Frequently Asked Questions

What is an annuity?

An annuity is a long-term investment that you can buy from an insurance company. The purpose of this investment is to help protect you from the risk of outliving your income. If you choose to, you can also convert your purchase payments into periodic payments that will last for the rest of your life or a specific period.

Is an annuity a good investment?

Annuities are a good investment for people who want a reliable income during retirement. Annuities are insurance products, not an equity investment like a mutual fund with high growth. The guaranteed protection makes annuities a good balance to a financial portfolio for someone close to or already in retirement.

What are the biggest disadvantages of annuities?

The primary disadvantage is annuities can be complex, your upside potential may be limited, you could pay more taxes in the future, fees can be high on certain products, penalties during the surrender period, guarantees can be irrevocable, and inflation can erode the annuity’s value.

Do annuities make money?

Fixed annuities earn a fixed interest rate similar to a Certificate of Deposit. Fixed indexed annuities earn interest based on the positive performance of a stock market index without risk. Variable annuities make money based on the performance of subaccount and have risk. Immediate annuities earn little to no interest.

What is the safest type of annuity?

Fixed and fixed indexed annuities are the safest type. Fixed annuities are guaranteed income products. They grow at a set interest rate, and the owner is protected from market volatility. This means that no matter what happens in the stock market or with interest rates, they will always have a guaranteed minimum payment that is earned on their investment. Fixed indexed annuities take the safety of a fixed annuity and add the potential for upside growth. They offer protection from market downturns while allowing the owner to participate in market gains, up to a cap. This means that if the stock market goes down, the annuity owner’s investment is protected. However, if the stock market goes up, the annuity owner can participate in the gains, up to a certain point.

What is an annuity account?

A financial product that allows you to save for retirement or other long-term goals. Accounts are tax-deferred, which means that you won’t have to pay taxes on the money you contribute until you withdraw it at a later date.

What is annuity income?

Annuity income is a fixed, regular payment that you receive from an annuity. The payments can be made monthly, quarterly, or even annually, and they are based on the amount of money that you have invested in your annuity account.

What is the definition of an annuitant?

An annuitant is a person who owns an annuity account. The annuitant is the one who will receive the payments.

What is the basic function of an annuity?

The basic function is to provide a stream of payments over a set period of time. Annuities can be used for retirement income, or they can be used as an investment vehicle to help grow your wealth over time.

Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on 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.

The Annuity Expert is an online insurance agency servicing consumers across the United States. 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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