What Are Annuities and How Do They Work?

Written By Sivea Key

Annuities were developed to ensure that, in exchange for a single large deposit, an individual or family would receive annual payments for the rest of their lives. Defined benefit pensions and Social Security are examples of lifetime guaranteed annuities.

Strategy At A Glance

Annuities have been around for millennia, providing people with a lifetime of income payments in retirement. Modern annuities are heavily regulated and have been creatively designed to fit many more life situations than those of the past. They can provide a foundation for your retirement income by providing an additional steady income similar to social security. Or they can be designed to provide income for college, fill years in your financial plan that would otherwise bring your budget into the red, or other shorter-term goals.

To make the best use of this financial tool, you need to decide what you want to use the income for, how long you have until you need the extra income, and how you want to pay the premiums. Finding the right fit for your goals means understanding how annuities work.

Four basic features of annuity plans define how they work:

  • How premiums are paid into the contract
  • When benefits are paid from the contract
  • How premiums accumulate in the contract and are invested
  • How the Internal Revenue Service identifies the contract for tax purposes

A History of Annuities

The idea of annuities has been around for a long time. In fact, the term “annuities” is based on the Latin word annua, which, in the Roman Empire, was applied to contracts that made annual payments. In the United States, one of the early recorded uses was by the Presbyterian Church in 1720.

While annuities in general have a venerable history, the policies we see these days first emerged in response to the stock market crash of the 1930s. Shocked by tumbling stock values and reassured by the growing number of group annuities used for company pension plans, eager investors looked toward individual annuities as a potentially more stable source of retirement income.(source) Defined benefit pensions and Social Security are familiar examples of annuities that were developed during this period.

After decades of slow evolution, the variety of annuities available to individuals suddenly expanded in the 1990s when insurance companies created complex new types of annuities with special focuses such as tax-sheltered growth, more flexible income options, and long term care riders. As with pretty much any explosive market expansion, the new products went through a chaotic period of experimentation that in the end required government intervention.

Two factors were the major contributors to the bad reputation annuities garnered from the “wild west” mentality.

  • Regulations were lax and unscrupulous insurance agents took advantage of investors. The worst annuity insurers often paid the highest commissions to agents to motivate insurance agents with low regard for their clients’ interests.
  • Actuarial information was in short supply of data on current lifespans and interest rates were very high which led insurance companies ot offer payments they didn’t have the financial strength to support.

New regulations were passed (and have recently been updated again) to monitor and control agents’ behavior and more accurate financial requirements for insurers strengthened security for buyers. Actuarial information matured which caused insurance companies to offer sustainable annuity plans. The experimentation with new models for annuities resulted in new products, better tailored to address a wider range of individual goals – annuities are no longer one-size-fits-all.

Annuities Today

Since 2019, rising interest rates, a chaotic stock market and better regulations mean that annuities are sought after by increasing numbers of people. More people looking for safer harbors for their retirement savings are buying annuities – and, in fact, the numbers continue to rise. In 2022, sales rose 23% over 2021 as some people purchased fixed annuities to lock in the new higher interest rates, and others purchased annuities to protect themselves from a wild stock market. During this time, the SECURE Act was passed, easing the 1986 regulation on using individual annuities as part of an FERS approved retirement package.

More companies offering individual annuities for retirement savings, stock markets continuing a chaotic course and interest rates remaining high are compelling reasons to learn how annuities work so you can decide whether buying an annuity is the right move for your family.

Choosing an Annuity

When considering what type of annuity to choose, first decide what you want the annuity to do for you.

Here is a list of some of the goals that can be met depending upon the type of annuity:

  • Replace CDs as a conservative investment method.
  • Provide a source for income for a lifetime. You can choose income payment schedule.
    • Set payments each month.
    • Increasing monthly payments to help with inflation.
  • Provide growth with or without investing directly in the market*.
    • Grows tax deferred – can be pre-tax or post-tax dollars.
    • Protection from market downturn for investments.
  • Long term care, short term care, and terminal illness benefits.
  • Death benefits for those that can’t qualify for life insurance.

If defining your goals isn’t coming easily, let’s set a time to talk. We’ll consider things like:

  • Where you are now in your career
  • Current demands on your income
  • What you may be facing in the next decade or two
  • What income you’re planning for your retirement
  • Preference for more or less risk in your retirement savings

Once you have a clear idea of your goals, it’s time to decide which type(s) of annuities will help you reach those goals. To help you zero in on what might work well for you, we’ve divided the features available in annuity contracts by what type of benefits they were designed to address. Keep in mind that the features listed below may be able to be combined, such as a “non-qualified, fixed premium, fixed indexed lifetime annuity”.

*We do not handle variable annuities, which are the only annuities that offer investment in the stock market, but we can help you find a FINRA licensed representative if you’re interested. Only Fixed Interest and Fixed Indexed annuities are discussed in this article.

Annuities as an Investment**

From the first invention of annuity contracts, the goal has been to invest during your working years to provide income when you retire. Roman workers mostly labored until they no longer could perform their duties before receiving annuity payouts. Today, we invest for our “golden years”, a time to pursue what we most enjoy without the demands of bosses and time tables. Our expectations and our life spans have changed tremendously since those times. That means we have many more years of paying for our lifestyles than the Roman workers. Most people choose annuities for the ability to receive a lifetime of payments which continue even when the initial investment runs out.

Like the annuities used in Ancient Rome, annuities today are mainly focused on retirement, but today’s versions offer a variety of new features. The first set of features we’ll consider is how you pay into the annuity and how the cash in the annuity grows.

Let’s look at annuity types that affect premiums, growth and taxes.



Single Premium vs Installment Premiums for Annuities

When choosing an annuity, consider whether you prefer to pay a single premium or installment premiums. Single premiums, or “lump sum” premiums, are the simplest. Often this one-time payment comes from retirement savings, a property sale, inheritance or other financial windfall.

Installment premiums can be “fixed” or “flexible”. A fixed premium is a set amount paid into the annuity during the savings or “accumulation phase” of the contract. An annuity with flexible premiums allows varied amounts to be paid into the annuity (within the limits of the contract) during this period. The accumulation phase ends when income payouts begin. (SEE “How Do Annuities Pay Out” below.)

Qualified vs Non-Qualified Premium Tax Treatment for Annuities

Depending upon the source of the money you want to pay into an annuity, you can choose a “qualified” or a “non-qualified” contract. Qualified annuities are designed for money invested before taxes are paid (pre-tax money) and fall under IRA regulations for retirement plans like an IRA or a pension fund. Choose a qualified annuity if you are paying for it with money rolled over from a 401(k), IRA, KEOGH or other retirement fund for which tax wasn’t paid on the money deposited into the retirement fund. As with any tax-deferred source, when you take income from the annuity, taxes are due on all money withdrawn.

Non-qualified annuities can be used for all other sources of income (after-tax income). The good news is that, much like qualified annuities, they grow tax-deferred. That means no taxes are due on any growth in the value of the annuities during the accumulation phase (the years before income is withdrawn). Because the money used to pay for the non-qualified annuity was already taxed, only the growth is taxable when you take income from the annuity.

Fixed Interest vs Fixed Indexed Growth** for Annuities

If you’re looking for a more conservative investment, consider “fixed interest” annuities as a replacement for a CD or a savings account. Fixed interest annuities pay a guaranteed minimum interest rate (minus any charges) throughout the length of the annuity contract. If you are looking for a higher than minimum guaranteed interest rate, look for a plan that offers locked in interest rates - generally offered for 2 to five years.

Generally speaking, compared to savings accounts and bank CDs, the advantages of fixed interest annuities are that they:

  • Typically pay better interest rates.
  • Protect your interest growth (“tax-deferred”) instead of interest being taxed as it’s earned.
  • Offer income for your lifetime (or for the lifetime of you and your spouse, whoever lives the longest.)

If you want protection from stock market losses but want to capture some of the growth potential of the stock market, consider a “fixed indexed” annuity. While not investing directly in the stock market – which protects you from market losses – you select from a group of stock funds and are paid interest based on the gains of that fund. If the fund loses money, you simply don’t have a gain for that year. If the fund gains money, your annuity value grows proportionally. It’s like climbing stairs – the stairs lead upward, but sometimes the steps are shorter or taller, and sometimes you walk across a flat landing to get to the next step up.

** We do not handle variable annuities, which are the only annuities that offer investment in the stock market, but we can help you find a FINRA licensed representative if you’re interested. Only Fixed Interest and Fixed Indexed annuities are discussed in this article. Unlike Fixed Interest and Fixed Indexed annuities, funds invested in variable annuities can be invested in the stock market, subject to market values, and therefore different factors affect most aspects of the contracts.

How Do Annuities Pay Out?

Much like Social Security, annuities can pay out a fixed amount on a regular schedule (usually monthly or annually) during the “Income Phase". Social Security pays cost of living increases to help retirees keep pace with inflation. Some annuities offer something similar by increasing payments based on growth in the value of your annuity. When you’re ready for your annuity to pay out, you will have some choices to make. The options available will depend upon the type of annuity you purchased.

Below, we’ll examine how some common options affect your income stream.



Tax-Qualified vs. Non-Qualified Annuities and Taxable Income

When you buy an annuity, the source of your payment affects the payout on the annuity. If you are rolling over tax-qualified (pre-tax) money, say from an IRA or a pension fund, or starting a new tax-qualified annuity, you will be liable for a tax penalty if you receive income before age 59 ½ , unless you qualify for a disability-exemption. Furthermore, the full income you receive is taxed, just like any other IRA or pension fund.

Outside of a tax-qualified fund, age doesn’t matter. With a non-qualified annuity, the growth on your money is tax-deferred but the premium you pay is after-tax dollars so that isn’t subject to tax. And a non-tax qualified annuity is not subject to a penalty fee before age 59 1/2. (Consult a tax expert to make sure you understand the tax ramifications of any annuity you consider purchasing.)

Age is a big factor in the percentage of the annuity value will be paid each time to the annuitant. (Different annuity contracts have different options for how often they pay you.) Annuities are designed to pay you a certain amount of money for a designated period of time, generally speaking. The older you are, the shorter the period of time the insurance company is likely to be making regular payments to you. That means that, for the same amount of money paid into an annuity, an older person is typically going to receive a higher payout than a younger person.

Choosing Between Lifetime vs Fixed Period Payouts for Annuities

The other big factor on what percentage of your annuity value will be paid out at a time is whether you choose to be paid for a lifetime or for a fixed period of time (5 years, 10 years, etc).

An annuity for one person paid out over a lifetime will pay less than if that person wanted to be paid for, only 5 years, for example. However, lifetime payments may still be the right choice because you can’t outlive lifetime payments. Imagine being able to count on a regular payment coming in every month for the rest of your life in addition to your social security. Even better, some annuities are set up so that your payments can continue to grow over time because the annuity value is set up to continue to grow.

Many annuity contracts allow more than one annuitant to join on the same contract. That means one account and one payout to cover all the joint annuitants. Most common options are for spouses. Because of the risk of one joint owner living a very long life, the insurance company will pay a lower income payment than for one person. But whenever one owner passes away, the payout remains the same. Since social security and some pensions stop when the owner dies, having a stream of income that doesn’t go away can be a life saver for the surviving spouse.

Rather than spreading payments out for a lifetime, you can choose a specific period of time to have payments made. The shorter the time span the higher each income payment will be. Age isn’t as much of a factor here because if you pass away before all payments are made, payments will go to the listed beneficiary.

Immediate vs. Deferred Annuities

Payout from annuities also depends on whether you purchase an “Immediate Annuity" or a “Deferred Annuity". The most commonly purchased annuities in 2023 were immediate annuities. Immediate annuities have no growth period; payments begin shortly after the start of the contract. Nearly all immediate annuities must be purchased with a single payment. Many offer some type of growth in the annuity value while it’s paying out, and payments can be made for a lifetime or for a set number of years. But, generally speaking, the options available for immediate annuities are more restricted than for deferred ones, and the payouts are lower for the same investment amount. A fixed or fixed interest, lifetime, single premium, immediate annuity is a safe way to guarantee you’ll receive income for the rest of your life.

On the other hand, money paid into a deferred annuity is designed for retirement. It’s a long term investment like social security and pensions - and, like social security and pensions, there’s a hit if you try to take it out earlier than 59 ½. In fact, a fee is charged if you take your money out before the end of the contracted growth period. This charge is called the “surrender fee", it’s specific to the annuity you buy, and reduces each year until it becomes zero at the end of the surrender period. Annuities are designed to be a long-term investment for retirement, so government penalties and insurance company surrender charges are built in to discourage early withdrawal. Take Away: Let it grow!

What is Annuitizing?

Different deferred annuities have different rules about when you can begin receiving regular income payments, called “annuitizing". Generally, you receive the most return from your annuity when you begin withdrawals after age 59 ½ and after the end of the surrender period. When buying an annuity, consider money that you want protected for retirement – even from the urge to spend it now. Choose a surrender period that fits your timeline. If you’re concerned about needing to provide your family with an emergency cushion of cash, look at the free withdrawal and crisis waiver options.

Crisis Waivers and Free Withdrawals During Accumulation Period

Even though annuities are designed for retirement income, not money for pre-retirement bills, “Free Withdrawals" and “Crisis Waivers" are ways some annuities help you through unexpected crises during the accumulation period (the “growth" phase of the annuity).

Most annuities these days allow for a free withdrawal of around 7-10% of the account value per year. “Free" means free from surrender charges and, typically, free from income tax since the IRS considers those withdrawals either as recovery of premium or as a loan. Just be careful to stay within the limits imposed by the contract.

Some annuities even offer “crisis waivers" which suspend surrender charges to allow for unexpected medical crises like the need for nursing home care or a terminal illness. Usually the contract includes a waiting period before the crisis waiver takes effect and certain criteria must be met to make a claim. Furthermore, limits may be placed on how much can be withdrawn at a time. If the annuity is specifically designed to offer long term care benefits, payments made from the annuity for long term care may also be income tax exempt.

How Does an Annuity Work After Death?

Death benefit payments vary with the type of annuity and its payout plan. As we discussed above, annuities come in a variety of types with a variety of payout options. Your choice when you buy a plan and again when you choose among the offered payouts along with the stage of the annuity when you pass determine what happens with the money in the annuity. Generally speaking, if you pass away before you begin receiving income payments from your annuity, your beneficiary(s) will receive the surrender value of your annuity. If you pass away while receiving payments, the annuity ends without payout to beneficiaries except for the following types of death benefits:
  • Lifetime for One Person: You can choose an annuity with an option for a death benefit.
  • Joint Tenant Lifetime Payout: If you have a joint tenant, such as a spouse, on your contract, the annuity will keep paying out the agreed upon amount until the joint tenant passes away.
  • Fixed Period: If you should pass away before the end date of the fixed period, your remaining payments will go to the beneficiary(s) named in the contract.

Putting it All together

Buying an annuity that has the features that work best for your goals means looking carefully at what each plan offers before committing. Then, sticking to your decision. Annuities are best used the way they were originally intended, which means having other assets available for other expenses.

Remember to consider:

  • How premiums are paid into the contract
  • When benefits are paid from the contract
  • How premiums accumulate in the contract and are invested
  • How the Internal Revenue Service identifies the contract for tax purposes

Next Steps

We’re here to bring you up to date analysis of annuities that might fit your requirements. We can also help you complete an overall financial plan using Retirement Analyzer to help you keep your goals and needs in sight.

Make an appointment with us for guidance at any point in your explorations of annuities. Or, if you prefer to do it yourself, check this blog list for more articles on ways that you might be able to use annuities to fill the gaps in your retirement plan and download the “Understanding Annuities: Fixed and Indexed Annuities" booklet below to learn more.

Disclosures:

Variable annuities require a FINRA licensed representative. We do not offer these products.  If you are interested in variable annuities, we can help you find a source.

All annuity guarantees are based on the claims-paying ability of the issuing insurance company.

Sivea Key https://www.retirementsafetyzone.com/
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