Annuity Blog

How Do Annuities Work? A Simpler Look

Posted by: Anne Morrison | Feb 06, 2015

inner workings

Annuities offer a way for individuals to make their retirement more comfortable. However, not many have really understood how they work and can easily be swayed by what they’ve heard or read.

In this post, we’ve compressed the most essential information you need to know to get a general understanding of how annuities work.

Let’s dive right in – hopefully, even if you only have a rough idea of what an annuity is, you’d have a clearer picture after reading this.

Basic Concepts

An annuity is an insurance product that pays out a stream of income, usually in retirement. It basically works like this: you invest an amount of money into an annuity from an insurance company, who then sends payments to you at a later date. The money you invested grows over time, and you can choose to receive payments for a set period of years or for the rest of your life.

This is explained in more detail here: What is an annuity?

Perhaps what confuses most is the variety in how different types of annuities provide this basic purpose. You can choose whether your investment grows at a fixed or variable rate, whether you start receiving payments soon or after several years, among others.

Kinds of Annuities

Annuities are generally either fixed or variable annuities and each of these can also be deferred or immediate annuities.

In fixed annuities, money in your annuity grows at a specified constant rate, so your returns are predictable. With variable annuities, you invest your money in one of the insurer’s “sub-accounts” composed of stocks and bonds, and your returns will depend on their performance.

Immediate annuities let you start receiving payments right away and continue on for a specific number of years or for life. Deferred annuities go through accumulation, where you earn interest on your money, and then distribution, where you then later start receiving income, usually after five years or more.

Note that the thousands of annuity products available today offer variations on these basic types, and then vary even further based on additional benefits, options and specific rates and conditions.

Ask Yourself

Before you delve into the details of actual annuity products, you should take time to consider your retirement goals and needs.

Have you maxed out your 401(k)s, IRA or other retirement accounts?

If you haven’t, make sure you contribute the maximum amounts there first before considering an annuity. These retirement accounts allow you to get big tax benefits that you should really take advantage of. Once you’re maxed out and you still have enough left to invest, you can then look at annuities.

How important is a stream of income in your retirement?

This stream of income is really the main benefit of an annuity. Most who get annuities appreciate having a guaranteed amount to rely on for spending every month, without worrying about managing a bigger amount. If you think that your investments and savings would be enough to see you through even with inflation, look at other options besides annuities.

How important is it to leave assets to your children?

The stream of income paid out by annuities will generally stop in the event of your death. Some annuities offer optional death benefits so that your heirs will receive any remaining amount. However, unless your annuity specifically has this, leaving a legacy to your heirs is not one of the strengths of annuities.

Recommendations

Annuities are some of the more complex and difficult to understand investments today. Due to this, it’s essential that you consult with a financial advisor before considering any annuity investments. With their help, make sure you understand all the fine print about each annuity so you are certain on how your money is invested and protected.

Perhaps more importantly, shop around. You want the insurance company you buy your annuity from to be financially solid and strong. Even then, you should still compare what annuities offer to other investments. Afterwards, you’ll feel more confident that you’ve made the right retirement choices.