Paperwork on desk with coffee cup considering types of annuities

What The Heck Is An Annuity? Everything You Need to Know

You’ve probably heard of annuities.

Depending on your retirement plan options, you might actually have an annuity.

But if you’re like most people, you recognize the term, but you don’t really understand how they work.

As with anything related to money, knowledge is power. Understanding the different types of annuities, how they work, and who they are best for can help you create a powerhouse investment portfolio that does – or doesn’t! – include annuities.

What are Annuities?

As pensions have become less and less prevalent, people are looking to fund their retirement in other ways. There are 401k plans, IRAs, and even 403(b) plans. Annuities are often pitched as an alternative to a pension.

Annuities are a long-term investment option that are actually insurance products, sold by either insurance companies or investment banks. You pay into an annuity each month or purchase one in a lump sum, and then you receive payments in periodic deposits over time (usually the life of the holder or their spouse). Some annuities allow you to cash in the full amount of your annuity upon retirement.

Annuities also come stamped with the promise that you won’t outlive your money. Sounds too good to be true, right?

It’s true that annuities are designed to last a lifetime, but they’re still not always the best option for everyone. Most annuities come with high fees, strict restrictions on how you can access your money, and lower returns than other investment options.

Annuities have gotten a bad rap because of less than clear disclosures on returns and fees, as well as aggressive sales tactics. But as annuities are still a huge part of 403(b) retirement savings accounts and are often offered to those approaching retirement, we wanted to break them down.

So, how do annuities work? Why do they exist, are there different kinds, and why might you buy one? This is what you need to know.

Annuity umbrella over a paper cutout person and hundred dollar bill

How Do Annuities Work?

An annuity is an insurance product that protects you from outliving your income. There are two phases to an annuity – The accumulation phase and the payout phase.

During the accumulation phase, you make regular payments that are invested in various ways (depending on the type of annuity) for your future.

Then, during the payout phase, usually at retirement, you start to get your payments back. Usually, these payments are paid out at a fixed monthly rate and may or may not include cost-of-living adjustments over time. Some policies do let you take a lump sum payment.

What Type of Fees Are There?

Annuities can run up significant fees. And they often come in many forms that aren’t easily understood if you don’t read through the long documents you sign when you buy them. (And even if you do read them, it might sound like jibberish.)

Here are the main fees to consider:

  • Commissions: Since most annuities are sold by brokers, large commissions can be tied into it. Even if they aren’t listed, they are likely built into your monthly cost and can run as high as 8%! Fixed rate annuities have the lowest commissions, ranging from 1% to 3%.
  • Annual fees: Variable annuities charge annual fees, often ranging from 2% to 3%. Considering “expensive” managed mutual funds charge 1% to 1.5% and index funds can have fees as low as 0.05%, you’re giving up a lot of ground.
  • Investment management fees: You’ll need to read the annuity prospectus (*snore*) to find the fees associated with your underlying investments, but those charges will still come out of your value.
  • Surrender fees: When you purchase an annuity, there is a period of time where you can’t withdraw your funds without a penalty (can be 5 to 10 years, or more). The surrender period typically depends on the length of your annuity, but you could pay up to 10% to withdraw your funds during the surrender period.
  • Insurance charges: Specific to variable annuities, these fees cover insurance associated with your annuity and administration fees.
  • Rider charges: Want your spouse to receive your payments if you die before them? Or want to get cost-of-living adjustments on your monthly payments during the payout phase? You can receive a rider, but there will be an additional cost.

These aren’t all the fees included in an annuity, but these are the most common ones. As you can see, the costs can add up to significant percentages of your assets, especially for variable annuities.

How Are Annuities Taxed?

All annuities grow tax-deferred (meaning you don’t pay taxes on gains or interest payments within your annuity account until you withdraw them), but how your payments are taxed differs based on how you purchased them.

If you purchase an annuity in an IRA, 401(K) or 403(B), annuity withdrawals or payments are treated like other investments in those accounts. The funds grow tax-deferred, but withdrawals are taxed as ordinary income.

This can be a benefit, as many people find themselves in a lower tax bracket in retirement than they are in during their working years.

Alternatively, if you bought an annuity with after-tax dollars, a portion of each payment will be viewed as a return of principal and not taxed, while the rest will be taxed as ordinary income.

This is a downside to purchasing annuities with after-tax dollars, as the ordinary income tax rate is typically higher than the long-term capital gains rate you would pay if you invested in stocks or bonds.

What Happens If I Die?

Remember how an annuity is technically an insurance product? Well, think of it this way.

Life insurance protects you if you die too soon. Annuities protect you if you live too long.

If you pass away early in your payout period, or even before your payout begins, the full value of your annuity – if any of it, will make it to your heirs.

For a fixed term annuity, an annuity that makes payments for a certain number of years, some plans have an option to name a beneficiary that will receive remaining payments. But while the annuity owner was guaranteed payments for the full term, the beneficiary will receive payments until the end of the term or when the account balance reaches zero. Whichever comes first.

For a life annuity, an annuity where you receive payments no matter how long you live, your benefits die with you. If you start receiving payments from an annuity at 70, only to pass at 72, the principal in your annuity is kept by the insurance company to be paid out to annuity holders who live longer than expected.

One way to get around this is to purchase a joint annuity, which pays out for the life of you and your spouse, whoever lives longer. But your children or other heirs will not receive the account value of your annuity.

What If I Die During the Accumulation Phase?

If you haven’t started to withdraw from your annuity yet, there typically are protections. Most companies will offer a death benefit for your beneficiaries, which is equal to your account value or the total of all premiums paid.

Paperwork on desk with coffee cup considering types of annuities

Types of Annuities

There are three main types of annuities: fixed, variable, and indexed. The main differences are how your deposits are invested – and whether your contributed dollars are protected.

What is a Fixed Annuity?

A fixed annuity is a type of annuity in which a person (the annuitant if you’re feeling fancy!) makes a lump-sum payment to buy an annuity, generally from a life insurance company.

In exchange for the lump-sum purchase, the insurance company will lock in two things: the principal investment and your interest rate. That means the money you put in upfront is guaranteed, as is the interest you receive on that money. Now you have a guaranteed rate of return with no risk in terms of your up-front payment.

Fixed annuities are treated as insurance products and regulated by state insurance commissions.

What is a Variable Annuity?

Whereas a fixed annuity as a guaranteed interest rate, a variable annuity does not.

With this type of annuity, you are investing in subaccounts. These subaccounts are made up of bonds, stocks, and even money market funds. The idea behind this kind of investing is that when the subaccounts perform well, the interest rate on your variable annuity can far outperform that of a fixed annuity.

The purpose of a higher interest rate is simple. You have the opportunity to grow your money faster and more dramatically. More money in retirement is a good thing. You also outpace inflation. $1000 in 1950 is not the same as $1000 today. You had a lot more buying power. The same will be true for money now versus in your retirement years. As a result, a higher interest rate helps keep you ahead of inflation.

Of course, the catch with this type of annuity is the risk factor. Fixed annuities guarantee your principal and the interest. A variable annuity does neither.

It is worth noting that many times variable annuities come with a death benefit. Essentially, in the event of your death before you start withdrawals, the people who you designate to get the money from your account get at least the initial investment amount.

Variable annuities are treated as investments and regulated by the SEC.

What is an Indexed Annuity?

An index annuity is a hybrid of a fixed and variable annuity, offering some of the higher returns from traditional stock investments.

With an indexed annuity, holders are credited with returns based on index performance, typically the S&P 500. This is not usually exactly equal to index performance but does offer higher potential returns than fixed annuities.

Indexed annuities are treated as insurance products and regulated by state insurance commissions.

Figure on investment newsprint considering downsides of annuities

The Drawbacks of Annuities

There are definite benefits to annuities in general, which means they can serve a role in your investment portfolio. However, as with any investment, the specific details matter.

While someone at one company might have a great annuity option, someone else might find their choices full of hidden fees. Arm yourself with an understanding of the possible drawbacks of annuities before you invest.

Costs

Annuities can come bloated with fees and other costs. What’s worse is that it is often times difficult to understand all the costs that come with an annuity because there are so many layers to them.

Like many investment accounts, there are fees related to managing your account. These fees are disclosed in the prospectus. While 1% or 2% does not seem like a significant amount of money, those rates can actually take a huge bite out of your income. The SEC estimates that 1% in fees can actually eat $30,000 or more from your retirement account.

Another significant drawback is a surrender charge. If you take your money out of your account within a certain time period (generally sooner than 10 or even 15 years), you will also pay a penalty called a surrender charge. That charge plus an account management fee can reduce your capital quite a bit.

Penalties

Another drawback to an annuity is that it doesn’t function like a regular savings account. If you are looking for a short-term or even mid-range savings or investment option, annuities aren’t it.

Access your money before 59 ½ years and you’re likely to be hit with a tax penalty. And it’s going to sting. 1% in account fees are going to look like pocket change compared to the 10% penalty you’ll pay if you need to take your money out early.

Lack of Transparency

The simple act of learning more about your annuity options can be overwhelming. Annuities and the insurance industry itself are not known for their financial transparency. In fact, it’s important to remember that insurance is a business. And it’s big business at that.

As a result, confused customers can sometimes make the best customers in terms of helping a company profit. The best way to guard against this is to be willing to ask questions. If nothing else, make sure you inquire about the fees and penalties and don’t be afraid to shop around.

Do annuities fit in your retirement plan?

Annuities Can Be Beneficial if You’re Scared of Running Out of Money In Retirement

Annuities – particularly fixed annuities – aren’t all bad. There are situations where they can be beneficial for your financial plan.

While there are specific, unique situations where annuities are beneficial – such as reducing required minimum distributions in 401(K)s, 403(B)s, or traditional IRAs – the biggest benefit is peace of mind.

If you’re scared of running out of money in retirement, a fixed annuity can give you a guaranteed monthly income that you can plan around.

Chances are, you’d end up with a greater net worth if you invested the money yourself because of the associated fees and lower growth rate. But investing isn’t for everyone. And as you approach retirement, you may want to purchase an immediate annuity or fixed annuity to ease your mind.

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Final Thoughts on Annuities as Investing Options

An annuity can offer great peace of mind when you are planning for your retirement. Fixed annuities are long-term investment options for those who are naturally risk-averse. Variable annuities can help you earn much higher returns (though they also come with much higher fees.)

When purchasing an annuity, work with companies that offer them directly to reduce commission fees and choose a company that is financially stable. You don’t want to purchase an annuity that no longer exists – or doesn’t have the funds to pay you – come retirement.

When you are trying to decide if annuities are the right option for you, the most important thing to remember is that the little details matter. The costs, penalties, and fine print can quickly outweigh a lot of the benefits of annuities, which is why it is so important that you explore your specific options before handing over your money.

We want to hear from you! Do you invest in annuities? Why or why not?

Should you invest in annuities? Everything you need to know

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