What Is an Annuity and How Does it Work?

FT Contributor  | 

An annuity is a retirement vehicle you pay into throughout your pre-retirement years that eventually begins to steadily pay you back after you retire. There are different types of annuities that behave in different ways, but adding an annuity to your retirement plan may ensure you’ve diversified your plan for income when you stop working.

If you’re worried about outliving your retirement income or you don’t think your current financial plan is diversified enough to keep you living comfortably through retirement, purchasing an annuity may help. Learning more about how annuities work and the different types that are available is important when attempting to create an investment portfolio that will help you prepare for retirement.

How Does an Annuity Work?

An annuity is a contract between you and a life insurance company or investment company. You provide a lump sum for the policy or pay through monthly installments. The money you pay to the insurance company or investment company for your annuity is invested, but not as aggressively as it would be invested if you purchased stocks and bonds instead. You continue paying into your annuity and the company continues to invest, growing your retirement money little by little.

When you’re ready to retire, you inform the company that you want to annuitize your account, or begin receiving regular payments from the investment. At this point, instead of paying into your annuity, your annuity begins to pay out money that you use as retirement income.

Depending on the type of annuity you purchased and how much you invested, you may receive regular payments for the rest of your life. If your annuity continues to pay after you’ve passed away, your payments go directly to a beneficiary until they run out.

Annuity vs. 401(k)

There are several differences between an annuity and a 401(k) retirement plan but both are considered investment vehicles. A 401(k) is an employer-sponsored investment vehicle you make contributions to through your paycheck.

The money you contribute is invested in mutual funds, exchange-traded funds (ETFs), and other investments you choose or the investment company chooses for you. You don’t owe income taxes on this retirement account until you’re ready to cash in on it.

Your annuity is similar to a life insurance policy. You invest in this retirement vehicle with after-tax money and the insurance or investment company uses your money for safe investments. When you begin to allow your annuity to start paying you, you owe income taxes on the payments. You can purchase an annuity on your own and don’t need an employer to assist you.

Types of Annuities

Fixed Annuities

Fixed annuities guarantee a fixed amount of interest earned for the life of the policy. While the interest you earn is usually less than it would be if you were investing in the stock market, you know the income is guaranteed and that you won’t lose out on your investment. Since the interest is fixed, the payout you’ll receive is also fixed.

Variable Annuities

If you purchase a variable annuity, you can choose from a few different investment options, which are sorted by risk factor. If you’re a conservative investor, you may choose an investment option that doesn’t amount to a large payout but is more guaranteed.

If you’re a risky investor and you choose a less conservative investment option, you’re gambling with your payout. Your annuity may eventually pay out with substantial interest or you could lose the money you invested due to a declining market. If betting on the market with your retirement vehicle makes you nervous, you may want to stick with a fixed annuity so you have a guaranteed payout.

Indexed Annuities

An indexed annuity is attached to a specific market index, such as the S&P 500 or Dow Jones. The way the market index behaves is the way the annuity will behave as well. If the market index shows profit and improvement, the annuity will grow. However, if the market index drops, the annuity value also drops.

When you’re ready to retire and have your annuity begin paying you, the payout you receive is directly related to the market index. If it performed well while your annuity was invested, your payout is higher than if it performed poorly overall.

Immediate Annuities

An immediate annuity begins to pay you back within a year after you begin your initial investment. If you’ve already retired but need additional retirement income or you’re on the verge of retirement age, this may be a useful financial tool.

You don’t have to wait for your annuity to grow before it begins to pay you back. However, the payout is not as high as it would be with a different type of annuity that was earning investment dividends for years.

Deferred Annuities

With a deferred annuity, you begin to receive payments at the date that’s specified in your contract. In most cases, you’ve paid into the annuity for several years before it begins to pay out. A deferred annuity is tax deferred. Therefore, you’re not responsible for paying taxes on the money you invest in it until you pull it out years later.

Pros and Cons of Annuities

An annuity is a helpful financial tool that can ensure you receive income in retirement. However, it’s important to review both the pros and cons of annuities before you begin investing for your retirement in this manner.

Pros

  • Guaranteed monthly payments: Ensuring you have enough retirement income to last for the rest of your life is worrisome. With an annuity, you’re guaranteed to receive monthly payments for an allotted period of time.
  • Easier to plan: When you know how much income you’ll receive in retirement from an investment vehicle, it’s easier to plan out when you can retire and how long the money will last.
  • Diversifying your investment portfolio: An annuity is another way to diversify your investments. Combining this financial tool with a few others ensures you’ll receive retirement income when it’s time to stop working.

Cons

  • Terms are set: When you agree to an annuity and the terms of distribution, there’s no way to edit the agreement.
  • Locking up money: You can’t get back the money you contribute to your annuity, so if you feel other investments would turn a higher profit, you may regret the money you’ve invested in this vehicle.
  • Service fees: Investment companies and insurance companies may charge high administrative and annual fees, which can affect the profit you make from your annuity.

An annuity may be a way to diversify your investment portfolio and ensure you receive monthly income when you retire. However, it’s important to understand the different types of annuities, how your money is invested, and the service fees associated with your contract before agreeing to it.


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