What is An Annuity (and How Annuities Work!)

Imagine getting paid $1000 every month for the rest of your life. You don’t need to work for it and you can spend it however you want. Sounds like a dream right? Well… all of this is possible with an annuity!

Of course, there are costs associated with annuities, but at a basic level, an annuity is a financial product that has the ability to provide you with comfort during retirement. Outside of a retirement plan, an annuity can also serve the purpose of converting a big windfall into a stable cash flow. This post will dive into exactly what an annuity is, how they work, different types of annuities, and more!

Let’s dive right in.

What is An Annuity?

Annuities are basically contracts issued by financial institutions where funds are invested with the goal of paying out a fixed stream of income to you later on. Their main purpose is to help out individuals in retirement. With an annuity, you’re very unlikely to outlive your savings as you’ll constantly have a series of payments coming in.

There are different types of contracts (which will be covered later in the post) but all annuity contracts say very similar things. Basically:

  • You will pay the financial instution / insurance company X amount of money throughout X amount of time.
  • In return you will receive X amount of money per month (or per year) starting from a certain date (annuitization).

While annuities can be perceived as having large up-front costs and also tedious early withdrawal rates, they can be a great option for people looking for a guaranteed stream of retirement income.

How Do They Work?

The reason these financial institutions are able to pay out guaranteed money to you is because you need to fund it first. It’s kind of like social security: steady cash flow until the individual passes away.

The period of time during which an annuity is funded is called the accumulation period. This is where you need to give money to the financial institution. The money is then in their management, and they can do what they want with it. Ideally, they will try to invest the money and grow it to reach their investment objectives so that they can make a profit even after funding your payments.

The period of time during which the financial institution pays you money is called the annuitization phase. This is where you get guaranteed payments every month. You basically get your money back! It’s not possible for annuity-holders to outlive their payments, which is a great hedge against longevity.

Also, you don’t necessarily need a long time to fund one. Single premium immediate annuities are often bought by people who have just won the lottery or who have won a lawsuit and received a huge lump sum of money. Most lottery winners go broke very soon because they spend all their money. With an annuity contract, they don’t have to suffer this curse as they can turn their lump sum into guaranteed cash flow.

Finally, most contracts have something called a surrender period and a death benefit. A surrender period is the period of time in which you can’t withdraw your money without receiving a surrender charge. It basically prevents you from changing your mind once you’ve made the purchase. A death benefit is the amount of money your beneficiary will receive if you die before the accumulation phase is over.

Annuity Terms

Here are some annuity related terms that you’ll want to get familiar with before investing anything:

  • Insurance Contract – synonymous with annuity contract.
  • Contract Owner / Annuity Owner – this is whoever owns the contract, so basically you!
  • Rate of Return / Interest Rate – different from an investment return, the rate of return for an annuity is the percentage by which it grows each year.
  • Purchase Payments – unlike the monthly payments you’ll be getting, purchase payments are the money you’ll need to pay in the accumulation period.
  • Contract Value – the total value of your annuity product / annuity products.
  • Fees – every contract will have an additional cost in the form of fees and commissions. Make sure to read the fine print.

Types of Annuities

As expected of such complex insurance products, there are lots and lots of different kinds of annuities. Some of the factors that can change are:

  • How long payments are to be made. Most annuities last until the owner dies, but it can also be made to only last a set amount of time (like 15 years for example).
  • When the annuity payment starts. With immediate annuities the payment starts right away. On the other hand, with deferred lifetime income annuities, the payments don’t even start after the initial investment (the client specifies a time in which they would like to start receiving payments). Someone might choose a deferred annuity because the terms may be better.
  • Fixed or variable. A fixed annuity provides regular stable payments to the owner. With variable annuities, though, how much you get paid can vary with how well your financial instutitions fund performs. (“Your” as in the financial institution or insurance company managing your funds).

Example

There are tons of annuity calculators out there but let’s take a look at one immediate annuity example here:

  • Premium Amount: $1,000,000
  • Age: 50
  • Gender: Male
  • Estimated Monthly Income: $2900

In this example, a 50-year-old guy decides to buy an annuity. This costs him one million dollars upfront but will pay him $2900 a month for the rest of his life. (Gender matters to financial institutions because males and females have different risk and longevity levels).

If we’re not factoring in inflation, in this example, the guy would need to live another 28 years for him to make back his money. So at 78 years old, his initial payment will have paid off! This seems like a pretty good deal at first glance because the average male life expectancy is 80 years, but when you factor in the rising cost of goods (inflation) the numbers don’t look as pretty.

This is a simple example, but at the end of the day most insurance products will follow a similar structure of initial cost, then later payout.

Best Fixed Index Annuities

One way to prevent inflation from stealing your wealth is to invest in fixed index annuities. Unlike fixed annuities, fixed index annuities pay you based on the performance of an underlying index (like the S&P500). Let’s say the S&P500 performed well and returned 10% in a given year. Depending on your participation rate, fees, and caps, your annuity payout could increase by 5-7%!

That’s an awesome way to hedge against longevity AND inflation. Win-win!

Some companies that provide popular fixed index annuities are:

  • Allianz Life
  • Great American
  • Symetra
  • Lincoln Financial Group
  • Pacific Life

Before diving in with fixed index annuities, be sure to look into exactly how the structure will work. Fixed index annuity rates vary from institution to institution and also from plan to plan. Plus, insurance brokers who sell these kinds of plans usually receive a large commission (which leaves one wondering where they are getting the money from). Just remember, I am not a financial professional. Be sure to do your own research and consult a financial advisor before investing any money into anything.

Conclusion

An annuity is a type of guaranteed income offered by insurance companies and financial institutions alike. With similar dynamics to mutual funds, these companies will grow the money you give them in investments. What’s different, though, is that you will get guaranteed income payments for the rest of your life after the accumulation phase.

Annuities are typically for retirees and for lottery (and lawsuit) winners to convert their money into guaranteed payments. You either pay a ton of money upfront or over a long period of time to receive guaranteed income once you hit your annuitization date. These financial products have their risks but overall are great for people who want stable cash flow later in their life.

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