What Is an Annuity?
An annuity is a financial product that pays out a fixed stream of payments to an individual, and these financial products are primarily used as an income stream for retirees. Annuities are contracts issued and distributed (or sold) by financial institutions, which invest funds from individuals. They help individuals address the risk of outliving their savings. Upon annuitization, the holding institution will issue a stream of payments at a later point in time.
- Annuities are financial products that offer a guaranteed income stream, used primarily by retirees.
- Annuities exist first in an accumulation phase, whereby investors fund the product with either a lump-sum or periodic payments.
- Once the annuitization phase has been reached, the product begins paying out to the annuitant for either a fixed period or for the annuitant's remaining lifetime.
- Annuities can be structured into different kinds of instruments—fixed, variable, immediate, and deferred income—which gives investors flexibility.
What Is An Annuity?
Annuities can also be created to turn a substantial lump sum into steady cash flow, such as for winners of large cash settlements from a lawsuit or from winning the lottery.
Defined benefit pensions and Social Security are two examples of lifetime guaranteed annuities that pay retirees a steady cash flow until they pass.
Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. Annuities can be created so that, upon annuitization, payments will continue so long as either the annuitant or their spouse (if survivorship benefit is elected) is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.
Buyers can purchase an annuity that offers an immediate payment or a deferred payment, depending on their individual retirement needs.
Annuities can also begin immediately upon deposit of a lump sum, or they can be structured as deferred benefits. An example of this type of annuity is the immediate payment annuity in which payments begin immediately after the payment of a lump sum.
Deferred income annuities are the opposite of an immediate annuity because they don't begin paying out after the initial investment. Instead, the client specifies an age at which they would like to begin receiving payments from the insurance company.
Fixed and Variable Annuities
Annuities can be structured generally as either fixed or variable. Fixed annuities provide regular periodic payments to the annuitant. Variable annuities allow the owner to receive greater future cash flows if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for less stable cash flow than a fixed annuity but allows the annuitant to reap the benefits of strong returns from their fund's investments.
While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to annuity contracts (usually for some extra cost) which allow them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value.
Other riders may be purchased to add a death benefit to the agreement or to accelerate payouts if the annuity holder is diagnosed with a terminal illness. The cost of living rider is another common rider that will adjust the annual base cash flows for inflation based on changes in the CPI.
Illiquid Nature of Annuities
One criticism of annuities is that they are illiquid. Deposits into annuity contracts are typically locked up for a period of time, known as the surrender period, where the annuitant would incur a penalty if all or part of that money were touched.
These surrender periods can last anywhere from two to more than 10 years, depending on the particular product. Surrender fees can start out at 10% or more and the penalty typically declines annually over the surrender period.
Annuities vs. Life Insurance
Life insurance companies and investment companies are the two primary types of financial institutions offering annuity products. For life insurance companies, annuities are a natural hedge for their insurance products. Life insurance is bought to deal with mortality risk—that is, the risk of dying prematurely. Policyholders pay an annual premium to the insurance company who will pay out a lump sum upon their death.
If the policyholder dies prematurely, the insurer will pay out the death benefit at a net loss to the company. Actuarial science and claims experience allow these insurance companies to price their policies so that on average insurance purchasers will live long enough so that the insurer earns a profit.
Annuities, on the other hand, deal with longevity risk, or the risk of outliving one's assets. The risk to the issuer of the annuity is that annuity holders will survive to outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.
Cash Value in Annuities
In many cases, the cash value inside of permanent life insurance policies can be exchanged via a 1035 exchange for an annuity product without any tax implications.
Agents or brokers selling annuities need to hold a state-issued life insurance license, and also a securities license in the case of variable annuities. These agents or brokers typically earn a commission based on the notional value of the annuity contract.
Who Buys Annuities?
Annuities are appropriate financial products for individuals seeking stable, guaranteed retirement income. Because the lump sum put into the annuity is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs to use this financial product.
Annuity holders cannot outlive their income stream, which hedges longevity risk. So long as the purchaser understands that they are trading a liquid lump sum for a guaranteed series of cash flows, the product is appropriate. Some purchasers hope to cash out an annuity in the future at a profit, however, this is not the intended use of the product.
Immediate annuities are often purchased by people of any age who have received a large lump sum of money and who prefer to exchange it for cash flows into the future. The lottery winner's curse is the fact that many lottery winners who take the lump sum windfall often spend all of that money in a relatively short period.
The surrender period is the period during which an investor cannot withdraw the funds from the annuity instrument without paying a surrender charge or fee. This period can run into several years and incur a significant penalty if the invested amount is withdrawn before that period. Investors must consider their financial requirements during the duration of that time period. For example, if there is a major event that requires significant amounts of cash, such as a wedding, then it might be a good idea to evaluate whether the investor can afford to make requisite annuity payments.
The income rider ensures that you receive a fixed income after the annuity kicks in. There are two questions that investors should ask when they consider income riders. First, at what age do they need the income? Depending on the duration of the annuity, the payment terms and interest rates may vary. Second, what are the fees associated with the income rider? While there are some organizations that offer the income rider free of charge, most have fees associated with this service.
Example of an Annuity
A life insurance policy is an example of a fixed annuity in which an individual pays a fixed amount each month for a pre-determined time period (typically 59.5 years) and receives a fixed income stream during their retirement years.
An example of an immediate annuity is when an individual pays a single premium, say $200,000, to an insurance company and receives monthly payments, say $5,000, for a fixed time period afterward. The payout amount for immediate annuities depends on market conditions and interest rates.
The Bottom Line
Annuities can be a beneficial part of a retirement plan, but annuities are complex financial vehicles. Because of their complexity, many employers don't offer them as part of an employee's retirement portfolio.
However, the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law by President Donald Trump in late December 2019, loosens the rules on how employers can select annuity providers and include annuity options within 401(k) or 403(b) investment plans. The easement of these rules may trigger more annuity options open to qualified employees in the near future.