An annuity can provide lifetime income, but there’s more to how an annuity works than meets the eye. If you ask an insurance company to define annuities, the marketing phrase the insurer will probably use is: “Annuities can produce an income stream you can’t outlive.”

That can be true. Annuity payments can last for as long as you live – or even longer – because the payments are based on your life expectancy. More valuable information will be provided in this article on what annuities are and how you can take full advantage of them.

• What is an Annuity
• Types of Annuities
• Annuity Fees and Commissions
• Annuity Calculator
• Are Annuities Safe?
• How Much Does a 100 000 Annuity Pay Per Month
• Who Should Not Buy an Annuity?
• What Happens to My Annuity After I Die?
• What Is the Best Age to Buy an Annuity?
• Pros and Cons of Annuities
• Why You Should Not Buy an Annuity
• How Long Can an Annuity Last
• What is The Minimum to Open an Annuity
• What is The Alternative to an Annuity
• When Can You Cash Out of an Annuity
• What is The 4% Rule For Retirement
• What to do With an Inherited Annuity

What is an Annuity

An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.

The goal of an annuity is to provide a steady stream of income, typically during retirement. Funds accrue on a tax-deferred basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59½.

Even though they may be marketed as investments, “annuities are not investments,”. “They’re contracts.” They lock you and the insurance company into contractual obligations, and breaking them – if that’s even possible – can come at a steep cost.

Types of Annuities

What Are Income Annuities

An income annuity is an annuity contract that is designed to start paying income as soon as the policy is initiated. Once funded, an income annuity is annuitized immediately, although the underlying income units may be in either fixed or variable investments. As such, income payments may fluctuate over time.

An income annuity, also known as an immediate annuity, a single-premium immediate annuity (SPIA), or an immediate payment annuity, is typically purchased with a lump sum payment (premium), often by individuals who are retired or are close to retirement. These annuities may be contrasted with deferred annuities that begin paying out years later.

Advantages of an Annuity

• If you’ve maxed out your contributions to other accounts offering tax-free retirement growth – like a 401(k) or IRA – an annuity could give another place to stash an additional nest egg.
  
• There are no annual contribution limits, which sets annuities apart from other tax-deferred accounts like a 401(k) or IRA.
  
• Annuity contracts do not have to be listed as assets on the Free Application for Federal Student Aid (FAFSA) form by parents applying for aid for their child’s education.
  
• Many investors prefer the stability and relative safety of the guaranteed return provided by annuities. The trade-off though is that annuities don’t offer the same kind of growth potential that other investments – such as stocks – do.
  
• Because you assign a beneficiary or beneficiaries for your annuity, the money shouldn’t be subject to probate fees or delays upon your passing. The benefit to your beneficiary is the higher of the current value of the annuity or the total amount you paid into it.

Disadvantages of Annuity

• High fees can often be associated with annuities, which can make them among the most expensive investment products on the market. Make sure you are aware of all fees, including initial commissions, ongoing investment management fees and early withdrawal fees. To test whether it is really worth it to take on the fees for an annuity, compare the cost of the annuity with a no-load mutual fund.
  
• Annuity income will be taxed just like ordinary income, so there is a chance that your tax rate could go up between now and the time you want your annuity to start paying out.
  
• Annuities may restrict your flexibility since early withdrawal often means paying a penalty. Experts refer to this as illiquidity. Some annuities do allow penalty-free partial withdrawals or disability/hardship exceptions to fees. Make sure you understand exactly when you will be able to access the money in the annuity and whether or not you will pay fees to do so.
  
• Many observers have pointed out that annuities restrict the investment options available and saddle investors with limited choices.
  
• Another common factor cited by financial professionals as a potential drawback of annuities is their complexity. Investors may not be able to fully understand exactly what the investment entails and thus may be at the mercy of the insurance company selling the product to be educated about the risks and rewards.
  
• Annuities aren’t insured by the FDIC or NCUA, but rather are covered up to a certain amount specified by individual states. For this reason, it’s important to understand how you are protected in your state should the insurance company offering the annuity go out of business.

Fixed Annuity

A fixed annuity is a type of insurance contract that promises to pay the buyer a specific, guaranteed interest rate on their contributions to the account. By contrast, a variable annuity pays interest that can fluctuate based on the performance of an investment portfolio chosen by the account’s owner. Fixed annuities are often used in retirement planning.

How a Fixed Annuity Works

Investors can buy a fixed annuity with either a lump sum of money or a series of payments over time. The insurance company, in turn, guarantees that the account will earn a certain rate of interest. This is known as the accumulation phase.

When the annuity owner, or annuitant, elects to begin receiving regular income from the annuity, the insurance company calculates those payments based on the amount of money in the account, the owner’s age, how long the payments are to continue, and other factors. This begins the payout phase. The payout phase may continue for a specified number of years or for the rest of the owner’s life.

During the accumulation phase, the account grows tax-deferred. When the owner begins receiving income, that money is taxed at their regular income tax rate. Annuity owners may also be allowed to make a limited number of withdrawals from the account before the payout phase begins.

What is a Variable Annuity?

A variable annuity is a type of annuity contract, the value of which can vary based on the performance of an underlying portfolio of mutual funds. Variable annuities differ from fixed annuities, which provide a specific and guaranteed return.

There are two elements that contribute to the value of a variable annuity: the principal, which is the amount of money you pay into the annuity, and the returns that your annuity’s underlying investments deliver on that principal over the course of time.

The most popular type of variable annuity is called a deferred annuity. Often used for retirement planning purposes, it is meant to provide a regular (monthly, quarterly, annual) income stream, starting at some point in the future. There are also immediate annuities, which begin paying income right away.

DEFERRED ANNUITIES

These delay payments until a future date (greater than one year). They enable people to increase their income stream later in life for less money because the insurance company is not on the hook as long when income payments are deferred. These appeal to people who want guaranteed income in the future, not now, or who want to create a ladder of income over different periods later in life. For example, they may want to work in retirement but know that eventually they will stop working and, at that point, and not before, will need guaranteed income from an annuity.

Annuity Fees and Commissions

Administrative Fees

Generally, you will also have to pay an annual fee to manage and administer your annuity. This could be higher than the fees on your IRA or 401(k). Typically, it’s about 0.3 percent of the value of your annuity contract. This can also be a flat fee, perhaps $25 or $30 a year.

Surrender Charges

Many annuity contracts will have built-in time periods at the beginning, usually for a set number of years, known as the surrender-fee period. During this time, you are charged a surrender fee if you withdraw money in excess of the scheduled payment amounts. Sometimes, the contract does permit limited withdrawals. If you withdraw more, you will incur a charge that can be as much as 7 percent of the value of the annuity. Typically, the percentage goes down over time. Longer surrender-fee periods usually mean the agent gets higher commissions.

Mortality Expenses

Mortality expenses compensate the insurance company for the risk it takes and may be charged by the company as a commission. This fee can range from 0.5 to 1.5 percent of the policy value each year.

Investment Expense Ratio

The cost of managing investments in a variable annuity is covered by the investment expense ratio. Variable annuities have investment and management fees. These fees can be referred to as expense ratios, 12b-1 fees or service fees. They can range from 0.6 percent to more than 3 percent each year.

Other Fees

Other charges may include transfer charges, distribution charges, third party transfer charges, contract fees, underwriting fees, and redemption fees.

Additionally, most annuity contracts carry general fees that are often listed as distribution fees or administrative fees and can range anywhere from 0.2 percent to just over 1 percent of the annuity value. These charges are applied for the management of the contract.

Commissions

All annuities have commissions, which are usually built into the price and not highlighted in the contract. Commissions are a portion of the annuity cost that is given to the agent. Usually, they’re known as trailing commissions. Trailing commissions are paid every year.

The commissions can be anywhere from 1 to 10 percent of the total value of your contract, depending on the annuity type. The more complex the annuity, the higher the commission. And the simpler and more straightforward the contract, the lower the commission. In 2014, Wells Fargo announced that it would only include fixed-indexed annuities that limited commissions to 4 percent.

Typical Commissions on Varying Annuity Types:

• Fixed annuities are the least complex annuity type and have lower commissions than other types. Fixed index annuities can have surrender periods as low as four years, but most have 10 years with a surrender charge. The commission on a 10-year fixed index annuity ranges from 6 to 8 percent.
• Commissions on single premium immediate annuities typically range from 1 to 3 percent.
• Deferred income annuities, also known as longevity annuities, charge commissions of 2 to 4 percent.
• Multi-year guaranteed annuities (MYGAs) usually have no fees, and the surrender periods range from three to ten years. Commissions on MYGAs are usually between 1 and 3 percent.

Annuity Calculator

This calculator can estimate the annuity payout amount for a fixed payout length or estimate the length that an annuity can last if supplied a fixed payout amount. Please use our Annuity Calculator to estimate the end balance of an annuity for the accumulation phase.

Are Annuities Safe?

As we have discussed in this article annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable annuities pose much more risk than fixed annuities. Variable annuities are tied to market indexes, which recessions tend to pummel.

Fixed annuities, by contrast, offer guaranteed rates of return. Though fixed annuities provide peace of mind during recessions, they tend to underperform, at least compared to their variable counterparts, when the economy is doing well. During good times, variable annuities reward investors willing to shoulder higher risk by providing, on average, more aggressive returns.

How Much Does a 100 000 Annuity Pay Per Month

The income you’ll receive from a £100,000 annuity will depend on the rate of interest, your age, how long you wish to delay your annuity payments, whether you choose a fixed rate that doesn’t increase with inflation or one that does, and whether you want a single or joint annuity.

Example

A 61-year-old man purchasing a £100,000 single annuity with an interest rate of 5% could take out a tax-free lump sum of £25,000 and get an annual income of £3,206 (based on a single, non-escalating annuity).

If he delayed the payments by 4 years, he could receive £4,571 – an increase of £1,365 per year, and a total of £21,550 in growth. The tax-free lump-sum would also increase in value.

Who Should Not Buy an Annuity?

You should not buy an annuity if Social Security or pension benefits cover all of your regular expenses, you’re in below average health, or you are seeking high risk in your investments.

What Happens to My Annuity After I Die?

There are several types of annuity payout plans. With some annuities, payments end with the death of the annuity’s owner, called the annuitant, while others provide for the payments to be made to a spouse or other beneficiary for years afterward.

The purchaser of the annuity makes the decisions on these options at the time the contract is drawn up. The options the annuitant chooses affect the amount of the payout.

What Is the Best Age to Buy an Annuity?

While the best age to purchase a deferred annuity will be different for each annuity investor, financial planners generally agree that sometime between the ages of 45 and 55 is optimal. Combined with additional retirement savings vehicles, the compounded tax-deferred interest earned and guarantee of lifetime income can provide a substantial retirement nest egg.

Age Time Frame

Between the ages of 45 and 55, an annuity investor is usually able to take on more risk with his or her investments than an older investor, as there will be more time for someone in that age group to make up for any losses. He or she also has a number of annuity options that are suited for individual financial goals and risk tolerance.

Beyond age 59, annuity investors are more likely to purchase an immediate annuity to provide guaranteed monthly income, as they fall outside the IRS 10% early withdrawal penalty. While an older annuity investor has the same choices a younger investor has, the often shortened time frame makes some of these options more suitable than others.

Pros of Annuities

Annuities offer some considerable benefits over other kinds of retirement investments, especially for those not able or willing to risk losing a portion of their retirement savings.

Pros of annuities include:

• Lifetime Income – With an immediate lifetime annuity contract, you are guaranteed periodic payments for as long as you live. The “risk” of you living a long and happy life is borne by the insurance company providing the annuity.

Social Security and pensions offer a similar form of retirement income protection – but in limited dollar amounts. The only limit to the size of your periodic annuity payment is the amount of money you have to purchase an annuity now. Even better for many retirees, the older you are, the larger your monthly payments will be for the same price.

• Inflation Protection – You can customize annuities to ensure that your monthly paycheck will keep pace with the cost of living. This is critically important because inflation can have a devastating effect on your assets. The downside of an add-on like inflation protection is that it will cost more – at an initial cost or in lower starting payments to begin with.
• Principal Protection – One of the best features of fixed and equity-indexed annuities is that the value of the annuity can be guaranteed to be at or above the amount invested. You can guarantee that you (or your heirs) will receive back at least as much money as you invested in the annuity.
• Tax Efficiency – The purchase of an annuity with qualified retirement savings (401k or IRA funds) can save you money on taxes over taking a lump sum payment. You can roll-over qualified funds into a qualified annuity without any tax penalties. You only pay taxes on the income the annuity provides.
• Predictability: According to a Towers Watson Retirement Survey, having predicable retirement income (presumably adequate income to cover all of your expenses) can help you feel happier.  Lifetime annuities provide that kind predictability.  Conversely,  the researchers discovered that retirees who must withdraw money from investments to pay for retirement expenses had the highest financial anxiety.

In summary, an annuity is a great way to protect your quality of life in retirement. Your retirement assets can be efficiently used to purchase guaranteed income to last as long as you need it. Best of all, this income can be protected from inflation and other financial woes.

Cons of Annuities

Despite the many advantages of annuities, they do have some downsides.

• Not All Annuities Are Created Equal – The financial planning community views some annuities – particularly fixed annuities – as being the ideal solution to a retiree’s need for guaranteed income. Fixed annuities have a very good reputation. However, other annuity products are viewed as “snake oil” – an unnecessary and expensive product. It is very important that you understand the various features and terms that are applied to annuities.
• Lower Returns on Your Investment – In return for the retirement income certainty provided by fixed annuities or equity-indexed annuities you forgo the opportunity to make bigger returns by investing your money in assets that fluctuate in value, like stocks. A fixed annuity is considered to be a safe and conservative investment but this means that you will not see the possible gains (and losses) of a riskier investment – like the stock market.
• High Costs: Sales commissions and management fees are a common complaint about annuities.  And, sometimes costs are definitely too high.  When purchasing an annuity, it is recommended that you shop around and really know exactly what you are paying for.
• Inflexible – Annuities are also typically less flexible than other retirement options – once you purchase an annuity contract your capital is tied up in the annuity, so you don’t have access to that lump of money.

Some retirement financial planners recommend that people reserve at least 40 percent of their retirement assets for unforeseen circumstances. Because most annuities are designed to provide steady income over time, they are not ideally suited to cover large unplanned expenses.

(However, although undesirable, if circumstances require it, there are third party companies that will exchange a lump sum payment for your fixed income payments. In this situation you will likely end up receiving less than the amount you paid for the annuity.)

Why You Should Not Buy an Annuity

1. Don’t buy an annuity if, after your death, your spouse is capable of managing the remaining assets and will not need a continuation of the income you were receiving.

An annuity can be structured to provide what is called “joint-and-survivor” income. This means that should the primary annuitant die, the surviving spouse would receive a portion or even all of the income continued for the balance of their life. However, buying an annuity with this feature will reduce the initial amount of income and may be less than you need in retirement. If you are sure that you will not be the first to die or are confident that your spouse will have sufficient assets and income for the balance of their life, there is no need to buy an annuity.

2. If your retirement plans may change.

One of the big selling points for a fixed annuity is that it is actually an insurance contract, and as such, it is based upon guarantees made by the insurance company. Unlike investments, when you put your funds in an annuity, the insurance company guarantees you will not lose any money (of course, you won’t make much, either), and once you start to draw down income in retirement, there is a guarantee the income will never be reduced or stop.

Guarantees are good — especially in retirement — but with that security comes inflexibility. Once you put money in an annuity and begin to receive income, you have given control of your funds to the insurance company and, should your circumstances change drastically (such as a major illness), there are only a few (very expensive) options available to respond to those changes. Because of this, you may not want to buy an annuity.

3. Don’t think it will be the be-all and end-all to retirement challenges.

Change never gets the memo when you retire. Even though you may have retired, change keeps right on working. As likely as not, you could spend 10, 20 or even more years in retirement. That gives change a lot of time to impact your life and plans. No one knows what those changes will be, but it is important to be in a position to respond to them.

By their very nature, annuities are “fixed” and are intended to be the antithesis of uncertainty and change. When you buy an annuity, you know what you have and what you can expect. That is the characteristic that makes an annuity such an important part of a retirement plan, but it also inhibits your ability to respond to change.

As a result, don’t buy an annuity thinking that it will solve all your challenges during retirement. Even though producing a guaranteed income an annuity can be a solid foundation for a retirement plan, it is not a good idea to put all your funds into an annuity. It is always prudent keep some of your assets aside so there is flexibility in the event of an emergency and even for the option of growth.

4. Don’t buy an annuity if you have successful experience managing your own money.

When you buy an annuity, you are basically asking an insurance company to take over and manage your retirement funds in exchange for providing you a monthly income. The insurance companies are more than happy to do this, but, of course, you will be charged initial and ongoing fees for this service. So, if you have experience and success managing your funds on your own and can convert your assets into an income, there is no reason to buy an annuity.

5. Don’t buy an annuity if you’re sure you have enough money to meet your income needs during retirement (no matter how long you may live).

It took a lot of time and hard work to accumulate your retirement assets, but it is easy to invest and “spend-down” these assets in order to provide necessary income during retirement. For instance, you could invest your money in mutual funds and withdraw a certain amount each month to cover living expenses. As long as you have accumulated sufficient funds so that you will not be concerned with the uncertain vicissitudes of the stock market — and are confident that you will not run short of funds, no matter how long you live — there is no need to buy an annuity.

A big part of an annuity is a guarantee that you will continue to receive an income, no matter how the stock market performs or how long you will live. However, the insurance company will charge a large fee to make this guarantee and sometimes even keep any remaining funds if you die before the amount deposited has been fully paid out. So, if you are confident that you have sufficient funds to last during retirement and don’t need an insurance company sending you a guaranteed monthly income, there is no reason to buy an annuity.

How Long Can an Annuity Last

The duration of an annuity depends on the specific terms in the annuity contract. Similar to life insurance, you have the option of choosing annuities that payout for different periods of time. For example, you could buy an annuity that lasts five, 10, 20 or even 30 years. Annuities that pay a guaranteed amount over a specific period of time are known as period certain annuities. If you happen to die before the end of the term, the remainder of the payments can go to a beneficiary such as a spouse or child.

Lifetime Annuities

Another option for annuities is to receive payments for the rest of your life. If you choose lifetime payments, your income payments can either be fixed or variable; fixed rate annuities pay a set amount, while variable rate annuities can pay different amounts based on the performance of underlying investments. When you die, your lifetime annuity ends — nothing is left behind to a beneficiary. Lifetime annuities can be attractive options for younger retirees who may live longer than 30 years.

What is The Minimum to Open an Annuity

Single-Premium Annuities

You can purchase a single-premium annuity, in which the investment is made all at once (perhaps using a lump sum from a retirement plan payout). The minimum investment is usually $5,000 or $10,000.

Flexible-Premium Annuities

With the flexible-premium annuity, the annuity is funded with a series of payments. The first payment can be quite small.

Immediate Annuities

The immediate annuity starts payments right after the annuity is funded. It is usually funded with a single premium, and is usually purchased by retirees with funds they have accumulated for retirement.

What is The Alternative to an Annuity

Retirement Income Funds

If you’re not sure how to withdraw money from your mutual funds, consider a retirement income fund. They’re actively managed to be able to deliver regular retirement income and they provide a solid, all-in-one investment management solution. They offer more flexibility than annuities, but they come with fewer guarantees.

You might consider putting a portion of your money in an immediate annuity for the guaranteed income, and a portion in a retirement income fund to provide you with more flexibility in the future. The key to making your money last will be to spend only the monthly income the fund provides to you without dipping into the principal.

Laddered Bonds

You might take a portion of your portfolio and buy bonds with different maturity dates if you want minimal risk. You can set it up so that one bond matures each year for the next 10 years. This is called building a bond ladder or an income ladder.

Each bond would meet your cash flow needs as it matures. You can use CDs as well as bonds for this purpose. Sell off some of your stock portfolio to buy the next bond each year as you spend one year’s investment. You might also build a 30-year bond ladder if you have enough savings. Like other options, this strategy might not provide as much income as an immediate annuity, but you’ll retain access to your principal.

Specified Withdrawals From a Total Return Portfolio

A portfolio of index mutual funds can be structured to pay out consistent income that will last over your life expectancy if it’s properly managed. You have to follow a set of withdrawal rules for this strategy to work—guidelines that tell you how much income you can take so you don’t run out.

This strategy doesn’t come with the guarantees that an immediate annuity provides, but you have the potential for an increase in income and you retain access to your principal. But you could experience a decrease in income if the investments perform poorly. 

Variable Annuity With a Guaranteed Minimum Withdrawal Benefit Rider

There are plenty of ways to create retirement income, but only a few of them come with guarantees. A guaranteed income rider is one option for achieving income that you can’t outlive. It’s an additional feature that can be added on to a variable annuity or an equity index annuity.

For an additional annual fee, the insurance company will guaranteed an amount you can withdraw for life at some point in the future. The terms of the guarantee are spelled out in the annuity contract. Unfortunately, you have to know exactly what you’re looking for and weed out the options with super high fees and additional bells and whistles that you’ll never use because they always cost more. 

When Can You Cash Out of an Annuity

Withdrawing money from an annuity can be a costly move, so make sure you review your plan’s rules and federal law before you do.

If you make withdrawals before you reach age 59 ½ , you will be required to pay Uncle Sam a 10% early withdrawal penalty as well as regular income tax on your investment earnings.

If your withdrawals come within the first five to seven years that you own the annuity, you probably will owe the insurance company a surrender charge. The surrender charge is typically 7% or so of your withdrawal amount if you leave after just one year, and the fee then typically declines by one percentage point a year until it gets to zero after year seven or eight.

Depending on when you purchased it, it might make sense to withdraw funds from your annuity, assuming your contract allows this. If you purchased your annuity recently, selling future payments may be a wiser choice.

Unlike people who bought annuities as part of a financial or retirement plan, structured settlement recipients are not allowed to withdraw money early. But you still have options, including selling future payments.

Or, if you haven’t yet received your settlement money, you may qualify for a type of cash advance to cover expenses while you wait.

What is The 4% Rule For Retirement

The Four Percent Rule is a rule of thumb used to determine how much a retiree should withdraw from a retirement account each year. This rule seeks to provide a steady income stream to the retiree while also maintaining an account balance that keeps income flowing through retirement. Experts are divided on whether the 4% withdrawal rate is safe, as the withdrawals will consist primarily of interest and dividends.

Simply put, is says you can withdraw 4% of your portfolio value each year in retirement without incurring a substantial risk of running out of money.

What to do With an Inherited Annuity

If you inherited an annuity as a listed beneficiary on the policy, you have a few distribution options.  Below are the primary choices that you have.

1. You can choose a lump sum payment.  This is a one-time lump sum payout upon the death of the annuity owner or annuity owners.
2. For non-IRA inherited annuities you can receive payments either a single life (based on your life expectancy) guarantee or a payout option that provides income for a specific period of time.
3. You can choose the “5-Year Rule” that requires the person who has inherited the annuity to receive the full distribution of the total dollar amount within 5 years of the owner’s death.  For an inherited annuity that is in an IRA, you have 10 years to take the funds.
4. Another choice is called a NonQualified Stretch.  This is for an inherited annuity outside of an IRA (i.e. non-qualified).  This strategy primarily involves a non-spouse inherited annuity and this inherited annuity stretch option allows you to receive RMDs (Required Minimum Distributions) based on your life expectancy.

Finally, annuities are a valuable tool intended to help you build a secure retirement plan, but before you buy, take the time to make sure you understand what an annuity can and cannot do, and be sure it is a tool you need and can use.