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Annuities: What they are and how they work

Pay you now, pay me later.
Written byColin Dodds
Colin Dodds
Colin Dodds is a writer, editor and filmmaker who has worked with some of the biggest companies in media, technology and finance including Morgan Stanley, Charles Schwab and Bank of America.
Fact-checked byDoug Ashburn
Doug Ashburn
Doug is a Chartered Alternative Investment Analyst who spent more than 20 years as a derivatives market maker and asset manager before “reincarnating” as a financial media professional a decade ago.
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Table of Contents
Read More
Deferred annuities
annuity
Senior-lady-looking-at-paperwork
Annuity income and taxes: Consider qualifications, deferrals, distributions, and more
An image showing documents related to a defined benefit pension plan, including a statement and Form 5500.
How defined benefit pension plans manage risk and returns
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Time + money = guaranteed income
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An annuity is an investment that offers a predictable income stream in retirement. You typically buy an annuity from an insurance company, either by paying one sum up front or by making payments over several years. In exchange, you receive regular payments during your retirement years.

That’s the simple explanation.

But prepare yourself: Annuities can become complicated rather quickly. They come in many forms, with a wide array of customizable features to choose from. With an immediate annuity, you invest and then start receiving payments right away. With a deferred annuity, your income stream begins at a later date. Some annuities offer set income payouts or income payments that increase with inflation, while others set payouts depending on the performance of the markets.

Key Points

  • An annuity offers a predictable income stream in retirement.
  • Annuities come in many forms, and some can be quite complex.
  • You can buy certain guarantees and add-on “riders” for annuities, but they can be expensive.

Annuities appeal to retirement savers for several reasons. They can offer a predictable income stream and help protect your savings from market downturns.

They’re also tax-advantaged—any growth within the annuity is tax-deferred until you begin receiving payments. Some contracts include optional add-ons, called riders, that offer guarantees such as lifetime income or payments to heirs.

How annuities work

In general, there are two phases of an annuity: accumulation and annuitization.

  • Accumulation. When you buy an annuity, you do so with a payment called a premium. This premium may be a lump sum (for example, money you received as an inheritance, excess proceeds from the sale of a home, or a chunk of retirement savings from a company 401(k) plan). Or you might choose to make monthly premium payments for several years. Either way, that first premium begins the “accumulation” phase. During this time, your money is invested according to the type of annuity you choose.
  • Annuitization. Once you’re ready to begin receiving payments, your investment sum is “annuitized” (i.e., converted into a stream of periodic payments, typically monthly or annually). In an immediate annuity, annuitization begins right after you’ve made your last premium payment. In a deferred annuity, the insurer invests your money throughout accumulation and begins distributing the proceeds throughout the annuitization period, which could be a fixed time period or for the rest of your life, depending on how the annuity is structured.

All else equal, a deferred annuity will result in a higher monthly payment than an immediate annuity, because that premium will be allowed to compound during the deferment period.

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Proponents of annuities point out that the insurance company takes on the market risk, as well as the risk that you’ll live long enough to take more payments out than you put in as premium. But in exchange for taking on these risks, the insurance company charges higher fees than most investment products. And then there are riders—optional alterations to the basic annuity contract designed to meet your specific needs. As a general rule, the more protections an annuity provides, the higher the fees will be.

Customize it—but be prepared to pay

Riders are optional features that let you tailor an annuity to better fit your needs. Common riders include death benefits, guaranteed minimums, spousal income options, and cost-of-living adjustments. These add flexibility and protection—but they also raise the overall cost. Learn more about how riders work and how to evaluate whether they’re worth it.

Types of annuities

  • Life annuity. A lifetime annuity offers benefits similar to a traditional pension plan. In exchange for a single lump-sum payment, a life annuity provides income for your entire life, and can even provide income for the lifespan of another person such as a spouse. But once invested, that lump sum is either impossible or costly to get back.
  • Fixed annuity. With a fixed annuity, the investor buys two guarantees from the insurer. The first is that the money put into the annuity will increase—or at least not decrease—in value, regardless of what the markets do. The second is that the income provided by the annuity will either remain steady or grow at an agreed-upon rate.
  • Variable annuity. Investors can purchase a variable annuity with a lump sum or a series of payments. That money goes into an account with a wide range of investment options, which grows on a tax-deferred basis. The income payments these annuities deliver can go up or down depending on how those investments perform.
  • Indexed annuity. Like a variable annuity, an indexed annuity offers income based on investment returns. But while the income in a variable annuity is based on investments you choose, the income provided by an indexed annuity is based on the growth or decline of a stock index such as the S&P 500. The relationship between the income payments and the performance of the index is determined by a complex formula.

Drawbacks of annuities

Although annuities offer predictability and long-term income, they come with trade-offs. Fees can be high, especially for contracts with extra features like guaranteed income or death benefits. Some annuities are also difficult to understand, with complex terms that can catch buyers off guard.

Liquidity is another concern. It may be costly or impossible to access your money once you’ve committed. And with some annuities, your income can fluctuate based on market performance, which means you might earn less than expected.

The bottom line

Annuities come in many shapes and sizes. And although they can make sense for investors who want a steady flow of income in retirement, they’re not for everyone. The idea of a guarantee can be attractive, but fees are an important consideration.

Because annuity contracts can be complicated, read the fine print and seek guidance from a financial advisor or other professional. If you’re weighing whether an annuity is the right fit, consider the pros and cons before committing. Once you buy an annuity, it can be difficult or costly to change your mind and get your money back. But if you do find one that offers the right mix of growth, stability, and reasonable fees, an annuity can help you create more predictable income and support your broader goals for retirement income planning.

References