What Is an Annuity and How Does an Annuity Work for Retirement?

How Does an Annuity Work?

An annuity is a contract between you and the insurance company that issues the contract. You make a lump-sum payment called a premium or series of payments and in return obtain 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 during retirement or growth and accumulation to access as needed or for just the death benefit for your beneficiaries. Funds accrue on a tax-deferred basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59 1/5.

Many features of an annuity can be customized to the specific needs of the annuitant. In addition to choosing between a lump sum payment or a series of payments to the insurer, you can choose when you want to annuitize your contributions or activate your income benefit - that is, start receiving payments. An annuity that begins paying out immediately is referred to as an immediate annuity, while those that start at a preset date in the future are called deferred annuities.

What Are Annuities Best Used For?

Annuities should be considered after you have met investment goals in IRAs, 401(k)s, and other retirement investment vehicles. Another important guideline to go by is to only invest in annuities when you have extra room for your retirement investment budget. If you can comfortably invest in an annuity and have a high income tax bracket, you can typically benefit from a maximum payout from ages  70 to 75.

Click Top Annuity Rates to see which annuities are a better fit for your personal goals. Remember to coordinate your retirement income goals with your financial advisor so you can fund annuities that you won’t outlive.

How Do Fixed Annuities Work

A Traditional Fixed Annuity has an interest rate that is guaranteed for one year at a time but has an ongoing minimum guaranteed rate as well. Sometimes this type of annuity has some sort of upfront bonus to enhance the first-year return only, which sometimes can be a little misleading. Also, many contracts allow you to add money to the policy.

One of the upsides to a Traditional Fixed Annuity is they normally track rising and falling interest rates, which can be a positive when it’s time to renew or lock in the annual rate on your annuity anniversary date.  

This can be a good strategy to guarantee a fixed rate every year, and you might have a chance in locking in any upswing in rates as well. Also, the contractional minimum guarantees are much higher when compared to the minimum guarantees of a Fixed Indexed Annuity.

One of the downsides to Traditional Fixed Annuities is when interest rates are too low and not very attractive then many insurance carriers will stop offering them. However, when rates move up then this strategy comes back into favor.

On the other hand, a MYGA also known as a “Multi Year Guaranteed Annuity" or a “Fixed Rate Annuity” function a lot like CDs. Basically, MYGAs in many ways are CDs but with tax deferral and are typically purchased with a single premium amount of money.

MYGAs pay a specified percentage yield for a contractually specified period. The big difference between CDs is that you pay taxes annually on the interest earned. With MYGAs you defer the taxes on the interest until money is taken out. Also, the interest compounds tax deferred, which is very important to know.  

The upside to Fixed Rate Annuities (MYGAs) is there are no internal fees, but the insurance company does pay a low commission (built in) to the agent or advisor out of a separate account and not your principal. Typically, MYGAs pay a higher contractional interest rate than CDs. Also, many contracts allow you to withdraw more than just the interest annually sometimes as much as 10% with no surrender fee.  With MYGAs you know exactly what your rate and contract value will be in the future guaranteed within the contract.

One of the downsides just like CDs is surrender penalties can be high if you want to surrender your contract before the specified period. Also, you must pay attention to the contract because some MYGAs automatically renew and restart for another specified guaranteed period unless you or your agent/advisor contact the carrier to let them know you will not be renewing your contract.  

How Does a Fixed Indexed Annuity Differ From a Fixed Annuity

A Fixed Indexed Annuity (FIA) is also considered an insurance contract whereas a variable annuity (VA) is considered a security. This contract is linked to the performance of an index without the risk though you’re not actually invested in the index.

With an FIA the insurance company assumes the risk whereas with a VA you assume the risk. Many FIAs have several indexing options including cap rates, (monthly or annual) limiting how much you can make on the upside but at the same time protecting your principal on the downside.

But there are also participation rates that have NO cap on the upside. For example, if your participation rate is 100% then you get 100% of what the index does from anniversary date to anniversary with NO risk to your principal and there are a few FIAs that have a participation rate greater than 100%.

If you're focused on accumulation or growth with no risk to your principal and taking withdrawals as needed then, in this case, you would not add an income rider.

If you're seeking income an income rider is advantageous if deferring income for many years though there are a few FIAs where you can start income immediately if over age 59 1/2. FIAs have low fees and in many cases have no fees at all unless a rider is added.

You can use an FIA to create an income for life like a pension. Some FIAs offer a bonus that is added to your contract value and income account value while others may only add the bonus to your income account value. 

The decision to purchase an FIA for income should not be based on the bonus alone but on whether this annuity meets your objectives. Many of these contracts offer riders with a specified interest rate applied to the income account value which is what your income would be based on once activated.

Most FIAs have a level payout or fixed income. Once they are activated there are a few with A+ rated companies that have an increasing payout option which has the potential to increase as index credits are added to the contract. This option is wise to consider if there is a long-time horizon that the income is needed to fight the effects of inflation.

What is a Variable Annuity?

A variable annuity (VA) is a type of annuity contract that allows for the accumulation of capital on a tax-deferred basis. As opposed to a fixed annuity that offers a guaranteed interest rate and a minimum payment at annuitization, variable annuities offer investors the opportunity to generate higher rates of returns by investing in stock and bond sub-accounts.

As mentioned, a VA is considered a security, unlike an FIA which is considered an insurance contract. With a VA you assume all the risk whereas with an FIA the insurance company assumes the risk thus you can lose principal with a VA.  If a variable annuity is annuitized for income, the income payments can vary based on the performance of the sub-accounts. You can add an income rider which will grow your income base at a specified interest rate.

Your income is typically based on an income benefit base which is your original investment or greater plus any interest earned from a rider or high-water marks that were locked in based on market performance. VA's typically have much higher fees than fixed annuities such as M&E fees, sub-account management fees, and rider fees.

What is a Single Premium Immediate Annuity?

A Single Premium Immediate Annuity or SPIA pays out immediately or no later than 12 months from issue. This type of annuity usually has a higher payout based on your age which sometimes people get confused with an interest rate. When choosing a payout option, you can choose a period certain that covers a specific period. For example, a 10-year period certain with life means if the annuitant passed away during the 10-year period certain the remaining balance of what has not been paid out goes to the beneficiaries.

If the annuitant lived past the 10-year period certain, then the income would continue for life but there would be no value left in the policy since the original premium has already been paid out. One thing to remember is that an SPIA is paying mostly principal back at first and has no growth element to it.

If you choose a life-only payout which is usually a higher payout and you passed away a month later the insurance company would keep the rest of the value in the contract. Sometimes planning early and having an equal amount of life insurance to cover the value of the SPIA in place would be wise if a death benefit is of concern. An SPIA is a very useful tool when applied correctly in covering specific needs that must be covered and is usually used with older individuals.

If an SPIA was funded with non-qualified money, then most of the income is excluded from taxation, and this is called an exclusion ratio which varies on the age of the annuitant. 

What is a Deferred Income Annuity?

A deferred income annuity (DIA), sometimes referred to as a longevity annuity, is a contract between you and the insurance company. You give an insurance company a lump sum in exchange for a guaranteed series of payments in the future. 

Deferred income annuities work like single premium immediate annuities (SPIA) but unlike an SPIA you can defer payments up to 45 years. DIAs typically have a much higher payout than SPIA's since you can defer out longer to a higher age. There are many different payout options depending on the issuing insurance company. Very few insurance companies offer DIAs.

What is a Qualified Longevity Annuity?

A Qualified Longevity Annuity (QLAC) works a lot like a DIA but is for qualified money like an IRA. Under IRS requirements RMDs are only required when the payments begin. You can defer RMDs to age 85. Click here for 'Top Annuity Rates'