Annuity

What is an annuity?

An annuity is a contract with an insurance company. You put money in, either once or over time, and the company agrees to pay you back, either as a lump sum later or as a stream of income. The core idea is simple: trade a sum of money today for income you can count on later.

Annuities are often used for one job: turning savings into retirement income that lasts as long as you do.

The two jobs an annuity can do

Accumulation

During the accumulation years, your money grows inside the contract, tax deferred, until you need it. This is the savings phase.

Income

During the income phase, the contract pays you. The payments can last for a set number of years or for the rest of your life, depending on the contract. Income you cannot outlive is the feature most people buy an annuity for.

The main types, in plain words

Fixed annuity

A fixed annuity pays a set interest rate for a set period. The growth is predictable, and the value does not fall with the market. The tradeoff is that the return is modest, and inflation can quietly reduce what the money buys over time.

Indexed annuity

An indexed annuity links growth to a market index, with a cap on the upside and a floor that protects the value from index declines. The growth can be higher than a fixed annuity in good years, and the value does not fall when the index falls. The exact cap and floor depend on the contract.

Variable annuity

A variable annuity lets you invest in a range of investment options inside the contract, similar to mutual funds. The value can grow more when markets rise, and it can fall when markets fall. Variable annuities usually carry higher fees, and they are the only type of annuity that can lose value from market declines.

Immediate income annuity

An immediate income annuity starts paying income soon after you buy it, often within a year. You trade a lump sum for a stream of payments. This is the simplest form of guaranteed lifetime income.

Deferred income annuity

A deferred income annuity starts paying at a date you choose in the future. Your money grows until then, and the payments start later, often larger because the wait was longer.

What is guaranteed lifetime income?

Guaranteed lifetime income means the insurance company promises to pay you for as long as you live, even if you live far longer than expected. That promise is the point. No other common retirement tool makes it.

The guarantee is only as strong as the company behind it. Guarantees are based on the claims paying ability of the issuing carrier, which is why the strength of the company matters.

The tradeoffs

Annuities are not right for everyone, and the tradeoffs should be clear before you buy:

• Access limits. Money in an annuity is meant to stay there. Taking money out early can trigger surrender charges and taxes.
• Surrender charges. Most annuities charge a fee if you withdraw more than a set amount during the first years of the contract. The charge usually declines over time.
• Fees. Some annuities carry annual fees, especially variable annuities and contracts with added income riders. Fees reduce growth.
• Complexity. Some contracts are hard to understand, and a contract you do not understand is a contract you should not buy.
• Inflation. A fixed payment buys less over time as prices rise. Some contracts offer rising payments, usually starting lower.
• Loss of control. Money used to buy lifetime income is generally no longer available as a lump sum.

Are annuities bad for you?

You may have heard that annuities are bad. The truth is more useful: an annuity is a tool, not a verdict. It is neither good nor bad on its own. It is good when it fits the job, and bad when it does not.

An annuity fits when the job is income you cannot outlive. A retiree who wants essential expenses covered for life, no matter how long life lasts, is using the tool for what it was built to do.

An annuity causes trouble when it is used for the wrong job. Putting most or all of your savings into one, buying one you do not understand, or paying high fees for features you do not need are the stories behind the bad reputation. The answer is not to fear the tool. It is to use the right amount, usually not more than half of your savings, understand the contract before you buy, and keep the rest of your money flexible.

Who does an annuity fit?

• Retirees and pre retirees who want income they cannot outlive
• People who have saved well and now need to turn savings into a paycheck
• People who want a portion of their retirement income guaranteed, while other savings stay flexible
• People who value certainty over the chance of higher returns

Questions to ask before you buy one

• Is the income guaranteed for life, or for a set number of years?
• What are the surrender charges, and for how long do they apply?
• What fees does the contract carry each year?
• What happens to the money if I die early? Does my family receive anything?
• How strong is the company making the promise?
• Does this fit with my other income, such as Social Security and any pension?

Common questions

Is annuity income taxable?

Generally, part of each payment may be taxable, depending on whether the money you put in was pre tax or after tax. Your tax advisor can explain how this applies to you.

Can I lose money in an annuity?

It depends on the type. A fixed or indexed annuity does not lose value from market declines. A variable annuity can lose value when markets fall. All annuities can lose value to fees, surrender charges, and inflation.

What happens to the annuity when I die?

It depends on the contract. Some pay a death benefit to your beneficiaries. Some stop paying when you die. Some continue paying a spouse. The contract should say so clearly before you buy.

How much of my savings should go into an annuity?

There is no single answer. A common guideline is not more than 50 percent of your savings, enough to cover essential expenses, while keeping the rest flexible. The right amount depends on your income, your expenses, and your other sources of income.

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Content on this page is for education only and does not constitute financial, tax, or legal advice. Please consult your tax advisor or attorney regarding your specific situation.