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What Is an Annuity?

Updated: Apr 17, 2023

An annuity is a long-term investment contract between you and an annuity provider that guarantees a stream of income during retirement.

Typically, you purchase an annuity from an insurance company, although some banks, brokerage firms or other financial services companies also sell them.

To buy an annuity, you make either a single payment or a series of payments. The payout from an annuity comes in one lump sum or through monthly, quarterly or annual payments over a certain period of time.

Fixed Annuity

A fixed annuity offers a guaranteed minimum return, such as 3% on your contributions. The annuity company might pay a rate that’s higher than the minimum rate, depending on how their investments perform.

The period when you’re contributing to a fixed annuity, either in one lump sum or gradually over time, is known as the accumulation phase. The period when you’re withdrawing money, also in one lump sum or over time, is called the distribution phase.

If you go with a series of payments, you can choose to receive them over a set number of years or throughout the rest of your life.

Pros of Fixed Annuities

  • Easy to understand. Some annuities are tough to figure out, but that’s not the case with fixed annuities. The rates and terms are almost always uncomplicated and straightforward. Contrast this with an index annuity, which has complicated rates and terms, plus a bunch of fees that can make them even more difficult to understand.

  • Guaranteed return. A fixed annuity locks in a minimum return on your investment that lasts throughout the life of the annuity contract. The rate of return for a fixed annuity might even be higher than the rate for a savings account or certificate of deposit (CD). Bank products like these are insured up to a certain amount by the Federal Deposit Insurance Corp. (FDIC) or National Credit United Administration (NCUA), whereas fixed annuities are protected by the guaranty association in your state.

  • Predictable income. A fixed annuity can make it easier to map out your retirement. Why? Because you can precisely forecast your annuity income, thanks to the fixed rate of return. This differs from variable and index annuities, whose income can fluctuate based on the performance of the underlying investments.

Cons of Fixed Annuities

  • No market gains. A fixed annuity is shielded from losses in the stock market. However, that means a fixed annuity won’t benefit from a strong market. Therefore, money invested in a fixed annuity does not benefit from stock market returns.

  • Potential loss of money. Unfortunately, payouts from a fixed annuity might be lower than what you paid into the annuity. For instance, the payout could be lower if you die soon after the payouts start, depending on what’s outlined in the annuity contract, especially if you forgo a guaranteed period.

  • Harm from inflation. High inflation might outpace the returns from a fixed annuity, meaning it won’t keep up with the rising cost of living. You can buy a cost-of-living rider, which is designed to ease the impact of inflation. However, this rider could chip away at the amount of some of your payouts.

Variable Annuity

The returns you earn from a variable annuity depend on the performance of investment funds you choose for your account. As you can guess by the name, the rate of return for a variable annuity changes based on the stock funds, bond funds and money market funds that you choose as investments.

Money contributed to a variable annuity grows on a tax-deferred basis, although the fees might exceed those of traditional investments.

The income you receive from a variable annuity depends on your contributions, either in a lump sum or through a series of payments, and on your investment gains. The income payouts might stretch out over a certain number of years or throughout your life.

Variable Annuity Pros

  • Tax-deferred status. You won’t pay taxes on investment returns until you pull money out of a variable annuity. A traditional individual retirement account (IRA) and a 401(k) typically enjoy similar tax treatments.

  • Possible high returns. Depending on the performance of the underlying investments, a variable annuity might deliver better returns than other kinds of annuities.

  • No contribution limits. Unlike a 401(k) or IRA, a variable annuity doesn’t cap annual contributions. So, if you’ve already reached your contribution limits on other retirement accounts, you could still put money into a variable annuity.

Variable Annuity Cons

  • Investment risk. Because a variable annuity is tied to securities, the money in your annuity might not gain value or might even lose value. The up-and-down nature of a fixed annuity’s value may make it harder to budget for retirement.

  • High fees. Fees for a variable annuity might exceed those for other kinds of annuities, as well as the fees for traditional investments.

  • Surrender charges. Withdrawing money or canceling the contract before the end of the surrender period could result in a severe financial penalty. Typically, surrender charges aren’t imposed until six to eight years after the contract takes effect.

Index Annuity

An index annutiy is a hybrid between a fixed annuity and variable annuity.

The rate of return for an index annuity tracks a market index like the S&P 500. Under this setup, the return for an index annuity changes more than a fixed annuity but less than a variable annuity. Therefore, there’s less risk and less potential return than with a variable annuity, and more risk but more potential return than with a fixed annuity.

An index annuity offers a minimum guaranteed interest rate along with an interest rate linked to a market index.

Pros of Index Annuities

  • Less risky than variable annuities. An index annuity lets you take advantage of market performance, yet it offers a guaranteed minimum return. Therefore, it offers some of the best of what a fixed or variable annuity can offer without the higher risk of a variable annuity.

  • Potentially better returns. Because of the market component, an index annuity might supply better returns than a fixed annuity, savings account or CD.

  • Safety. Because an index annuity safeguards your money against market losses, it’s considered a fairly safe investment.

Cons of Index Annuities

  • Riskier than fixed annuities. Because an index annuity is linked to the stock market, it comes with more risk than a fixed annuity does.

  • Cap on interest rate. Some index annuities limit the amount of interest you can earn. So, if the index tied to the annuity delivers returns of 10% but the interest cap is 8%, then you’d lose out on some of the investment gains.

  • High fees. The high fees charged for a fixed annuity can water down the investment gains. So, lower-fee investment options might enable you to keep more of your gains. However, those options might not provide protection against market losses, as index annuities do.

Other Types of Annuities

Single Premium Immediate Annuity

A single premium immediate annuity (SPIA) lets you make a lump-sum deposit into an account and starts providing monthly payouts immediately or within a year of the purchase.

While the immediacy of the payments can be attractive, keep in mind that you’re tying up a lump sum of money all at once.

Flexible Premium Deferred Annuity

Rather than buying an annuity with a lump sum of money, a flexible premium deferred annuity allows you to pay into the account over time.

Payouts are deferred, meaning they’re not immediate but instead are stretched out over a set period of time.

Qualified Longevity Annuity Contract

A qualified longevity annuity contract (QLAC) is designed to help insure you don’t outlive your retirement savings.

QLACs are deferred annuities that provide you with a guaranteed stream of income later in life. In addition, they can reduce mandated retirement account withdrawals—so-called required minimum distributions (RMDs)—which helps defer some income taxes.

Qualified Annuity

A qualified annuity is purchased through a workplace-sponsored retirement plan, such as a traditional IRA or traditional 401(k).

It’s funded with money that hasn’t been taxed. Taxes come into play when you withdraw money from a qualified annuity.

Non-Qualified Annuity

Someone can buy a non-qualified annuity no matter whether they participate in an employer-sponsored retirement plan or not.

A non-qualified annuity is funded with money that’s already been taxed. Earnings from a non-qualified annuity are taxed, but the contributions to the annuity are not.

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