how an annuity works
annuities are designed to provide a steady cash flow for people during their retirement years to alleviate the fear of outliving their assets since these assets may not be enough to sustain their standard of living some investors may turn to an insurance company or other financial institution to purchase an annuity contract as such these financial products are appropriate for investors known as annuitants who want stable guaranteed retirement income because invested cash is illiquid and subject to withdrawal penalties it is not recommended that younger individuals or those with liquidity needs use this financial product an annuity has different phases these are called annuities can be immediate or deferred immediate annuities are often purchased by people of any age who have received a large lump sum of money such as a settlement or lottery win and who prefer to exchange it for cash flows into the future deferred annuities are structured to grow on a tax deferred basis and provide annuitants with guaranteed income that begins on a date they specify 1variable annuities are regulated by the securities and exchange commission sec and state insurance commissioners fixed annuities are not securities and therefore are regulated by state insurance commissioners rather than the sec indexed annuities are normally regulated by a state insurance commissioner if they are registered as securities they are regulated by the sec as well the financial industry regulatory authority finra also regulates variable and registered indexed annuities 2agents or brokers selling annuities need to hold a state issued life insurance license and a securities license in the case of variable annuities these agents or brokers typically earn a commission based on the notional value of the annuity contract annuities often come with complicated tax considerations so it s important to understand how they work as with any other financial product be sure to consult with a professional before you purchase an annuity contract other considerationsannuities usually have a surrender period annuitants cannot make withdrawals during this time which may span several years without paying a surrender charge or fee 3investors must consider their financial requirements during this time period for example if a major event requires significant amounts of cash such as a wedding then it might be a good idea to evaluate whether the investor can afford to make requisite annuity payments many insurance companies will allow recipients to withdraw up to 10 of their account value without paying a surrender fee however if you withdraw more than that you may end up paying a penalty even if the surrender period has already lapsed there are also tax implications for withdrawals before age 59 4because of the potentially high cost of withdrawals some hard up annuitants may opt to sell their annuity payments this is similar to borrowing against any other income stream the annuitant receives a lump sum and in exchange gives up their right to some or all of their future annuity payments 5contracts also have an income rider that ensures a fixed income after the annuity kicks in there are two questions that investors should ask when they consider income riders individuals who invest in annuities cannot outlive their income stream which hedges longevity risk so long as the purchaser understands that they are trading a liquid lump sum for a guaranteed series of cash flows the product is appropriate some purchasers hope to cash out an annuity in the future at a profit however this is not the intended use of the product defined benefit pensions and social security are two examples of lifetime guaranteed annuities that pay retirees a steady cash flow until they pass annuities in workplace retirement plansannuities can be a beneficial part of a retirement plan but annuities are complex financial vehicles because of that complexity many employers don t offer them as part of an employee s retirement portfolio however the passage of the setting every community up for retirement enhancement secure act signed into law by president donald trump in 2019 loosened the rules on how employers can select annuity providers and includes annuity options within 401 k or 403 b investment plans 6the easement of these rules may result in more investments by qualified employees in annuities types of annuitiesannuities can be structured according to an array of details and factors such as the duration of time that payments from the annuity can be guaranteed to continue as mentioned above annuities can be created so that payments continue as long as either the annuitant or their spouse if survivorship benefit is elected is alive alternatively annuities can be structured to pay out funds for a fixed amount of time such as 20 years regardless of how long the annuitant lives annuities can begin to payout immediately upon deposit of a lump sum or they can be structured for deferred benefits the immediate payment annuity begins paying once the annuitant deposits a lump sum deferred income annuities on the other hand don t begin paying out after the initial investment instead the client specifies an age at which they would like to begin receiving payments from the insurance company depending on the type of annuity you choose the annuity may or may not be able to recover some of the principal invested in the account in the case of a straight lifetime payout there is no refund of the principal payments simply continue until the beneficiary dies if the annuity is set for a fixed period of time the recipient may be entitled to a refund of any remaining principal or their heirs if the annuitant has deceased 7annuities can be structured generally as fixed variable or indexed while variable annuities carry some market risk and the potential to lose principal riders and features can be added to them usually for an extra cost this allows them to function as hybrid fixed variable annuities contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value 8other riders may be purchased to add a death benefit to the agreement or to accelerate payouts if the annuity holder is diagnosed with a terminal illness the cost of living rider is another common rider that will adjust the annual base cash flows for inflation based on changes in the consumer price index cpi criticism of annuitiesone criticism of annuities is that they are illiquid deposits into annuity contracts are typically locked up for an extended period of time known as the surrender period the annuitant incurs a penalty if all or part of that money is withdrawn these periods can last anywhere from two to more than 10 years depending on the particular product surrender fees can start out at 10 or more and the penalty typically declines annually over the surrender period 93another criticism is that annuities are complex and costly at times individuals may buy an annuity without clearly knowing how they work or the costs involved be sure to do your research to understand all fees charges expenses and potential penalties 8annuities vs life insurancelife insurance companies and investment companies are primarily the two types of financial institutions offering annuity products for life insurance companies annuities are a natural hedge for their insurance products life insurance is bought to deal with mortality risk which is the risk of dying prematurely policyholders pay an annual premium to the insurance company that will pay out a lump sum upon their death if the policyholder dies prematurely the insurer pays out the death benefit at a net loss to the company actuarial science and claims experience allow these insurance companies to price their policies so that on average insurance purchasers will live long enough so that the insurer earns a profit in many cases the cash value inside of permanent life insurance policies can be exchanged via a 1035 exchange for an annuity product without any tax implications 109annuities on the other hand deal with longevity risk or the risk of outliving one s assets the risk to the issuer of the annuity is that annuity holders will survive to outlive their initial investment annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death examples of an annuitywho buys annuities annuities are appropriate financial products for individuals seeking stable guaranteed retirement income because money put into an annuity is illiquid and subject to withdrawal penalties it is not recommended for younger individuals or for those with liquidity needs annuity holders cannot outlive their income stream which hedges longevity risk 