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How does an annuity work?

An annuity is a contract between a purchaser (the annuitant) and an insurance company that promises to pay a certain amount of money, periodically, for a specified duration. It is typically used for retirement as a guaranteed income insurance for life.

There are many types of annuities, but the two most basic ones are a deferred and an immediate annuity. A deferred annuity means that a purchaser is contributing and accumulating capital over a working life to build a guaranteed income stream for his retirement. This period of regular contributions and internal tax-sheltered growth is called the accumulation phase. When the purchaser of such a deferred annuity is ready to start receiving income from this annuity, it is called the distribution phase.

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With an immediate annuity, a person gives a lump sum to an insurance company and immediately begins receiving regular payments, which can be a fixed, guaranteed amount, or variable, depending on the annuity package. A fixed annuity offers a very low-risk guaranteed income stream in retirement — the retiree receives a fixed amount every month for the rest of his life. Variable annuities allow the purchaser to participate in potential appreciation of assets while receiving an income from the annuity. With this type of annuity the minimum income stream is typically guaranteed but offers excess payments that fluctuate with the performance of the underlying portfolio of investments.

An important aspect of annuities is that they offer tax-sheltered growth. If someone contributes to a deferred variable annuity for a long period, he can offer significant long-term returns. Earnings are not taxed until they are withdrawn. However, it’s worth noting that upon withdrawal gains are taxed as ordinary income.

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Annuities can be extremely complex and can come with high fees and high surrender charges for the first few years, potentially as long as 10 years. It is important to keep in mind that the money used to buy an annuity is not “liquid.” If you need access because of unexpected life events, the money will be subject to high fees upon withdrawal.

Annuities can have many different “riders” that offer different kinds of guarantees such one called a “death benefit” that pays a certain amount of money to a beneficiary in case of premature death of the annuity owner. Another, a guaranteed number of payment years: If the buyer dies before the guaranteed payment period is over, the insurer pays the remaining funds to the annuitant’s estate. Generally, the more guarantees inserted into an annuity contract, the smaller the monthly payments will be.

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Annuities have received a bad rap lately because of their high fees. However, they can play an important role in retirement income planning by providing a guaranteed monthly income for life, much like a pension. The goal of an annuity is to provide a stable income supplement for life on top of one’s Social Security checks and retirement account withdrawals. It’s a useful tool, but one needs to be a savvy financial planner to understand the ins-and-outs of the various fees and how they may impact the overall deal.

When shopping around for an annuity, you should also take into account the insurance company’s financial strength. Even though in the event of a default, purchasers usually don’t lose their principal, they may lose additional benefits that were wrapped into the annuity package.

As with all financial matters, your financial goals and unique situation should be carefully examined. A qualified financial planner can help buy the right kind of annuity that is in perfect alignment with your needs.

Michael Philips is the founder and owner of Financial Mastery Wealth Management and a Registered Investment Advisor in California. 

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