If you are considering buying an annuity to provide steady income in retirement, it is important to understand the different types and how they work. Here is a look at the basics of annuities and what to consider before making a decision.

Annuities: The Big Picture

An annuity is a contract between the contract holder, the annuitant, and an insurance company. In exchange for your contributions, the insurer agrees to pay you a certain amount of money periodically over a specified period. Many people buy annuities as a form of retirement income insurance, guaranteeing a regular income stream after they leave the workforce, often for the rest of their lives.

Tax Advantages

Most annuities also offer tax advantages. Investment earnings grow tax-free until you begin withdrawing income. This feature can appeal to retirement savers, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding on their investments, with guaranteed cash flows paid in the future.

Penalties

Annuities typically have provisions that penalize investors who withdraw funds early. Tax rules also generally encourage investors to delay withdrawals until they reach a minimum age. However, most annuities allow investors to make withdrawals for qualifying purposes without a penalty, and some annuity contracts allow annual withdrawals of up to 10% to 15% for any purpose without a penalty.

High Fees Compared with Other Types of Investments

Compared with other types of investments, annuities can also have relatively high fees.

How Do They Work?

There are two main categories of annuities, based on when payments begin: immediate and deferred.

Immediate Annuities

With an immediate annuity, also known as an immediate-payment annuity, you give the insurance company a lump sum and begin receiving payments immediately. Those payments may be a fixed or variable amount, depending on the contract.

You might typically choose this type of annuity if you receive a one-time windfall, such as an inheritance. People approaching retirement may also take a portion of their retirement savings and buy an immediate annuity to supplement income from Social Security and other sources.

Deferred Annuities

Deferred annuities are structured to meet a different investor need: accumulating capital during your working years that can later be converted into an income stream for your later years.

The contributions you make to the annuity grow tax-deferred until you take income from the account. This period of regular contributions and tax-deferred growth is called the accumulation phase.

You can purchase a deferred annuity with a lump sum, a series of periodic contributions, or a combination of the two.

Types of Annuities

Within the broad categories of immediate and deferred annuities, there are also several different types to choose from. These include fixed annuities, indexed annuities, and variable annuities.

Fixed Annuities

A fixed annuity provides a predictable source of retirement income with relatively low risk. You receive a specified amount of money each month for the rest of your life or another period you have chosen, such as 5, 10, or 20 years.

The Return on a Fixed Annuity

Fixed annuities offer the security of a guaranteed rate of return. This holds true regardless of whether the insurance company earns enough on its own investments to support that rate. In other words, the risk falls on the insurance company, not on you. That is one reason to make sure you are dealing with a financially sound insurer that receives high ratings from the major insurance company credit rating agencies.

The disadvantage of a fixed annuity is that if investment markets perform unusually well, the insurance company, rather than you, will reap the benefits. In addition, during a period of high inflation, a low-paying fixed annuity can lose purchasing power year after year.

Financial Industry Regulatory Authority

Your state's insurance department has jurisdiction over fixed annuities because they are insurance products. State insurance commissioners require advisors to hold an insurance license to sell fixed annuities. You can find contact information for your state's insurance department on the website of the National Association of Insurance Commissioners (Reference #1 at the end of this article).

Indexed Annuities

Indexed annuities, also called fixed-indexed or equity-indexed annuities, combine the features of a fixed annuity with the possibility of additional investment growth, depending on financial market performance. You are guaranteed a certain minimum return, plus a return linked to any increase in the relevant market index, such as the S&P 500. However, participation in the index is generally capped.

Regulation

Indexed annuities are regulated by state insurance commissioners as insurance products; in most states, agents must hold both an insurance license and a securities license to sell them. The Financial Industry Regulatory Authority (FINRA), a self-regulatory organization (SRO) for the securities industry, also requires its member firms to monitor all products their advisors sell. If you work with a FINRA member firm, you may therefore have another set of eyes informally watching the transaction. This FINRA investor alert provides more details (Reference #2).

Variable Annuities

Unlike indexed annuities, which are linked to a market index, variable annuities provide a return based on the performance of a portfolio of mutual funds that you, as the annuitant, have selected. The insurance company may also guarantee a certain minimum income stream if the contract includes a guaranteed minimum income benefit (GMIB) option.

Regulation

Unlike fixed and indexed annuities, a variable annuity is considered a security under federal law and is subject to regulation by the Securities and Exchange Commission (SEC) and FINRA (see link #3 in the References section at the end of this article). Prospective investors must also receive a prospectus.

When you buy an annuity, you are betting that you will live long enough to get your money's worth—or, ideally, more than that.

Tax Benefits of Annuities

Annuities offer several tax benefits. Generally, during the accumulation phase of an annuity contract, your earnings grow tax-deferred. You pay taxes only when you begin withdrawing money from the annuity. Withdrawals are taxed at the same rate as your ordinary income.

If you fund an annuity through an individual retirement account (IRA) or another tax-advantaged retirement plan, you may also be entitled to a tax deduction for your contribution. This is known as a qualified annuity.

The Distribution Phase

Once you decide to begin the distribution phase of your lifetime annuity, notify your insurance company. The insurer's actuaries will determine the amount of your periodic payment using a mathematical model.

The main factors in the calculation are the account's current dollar value, your current age—the longer you wait before taking income, the larger your monthly payments will be—the expected future inflation-adjusted returns on the account's assets, and your life expectancy according to standard industry life expectancy tables. Finally, any spousal provisions included in the contract are factored into the equation. Most annuitants choose to receive monthly payments for the rest of their lives and their spouse's life, should their spouse outlive them.

If you live for a long time after you begin receiving distributions, the total value you receive from your annuity contract could be significantly greater than what you paid into it. However, if you die relatively soon, you may not get your money's worth.

Annuities can have many other provisions, such as a guaranteed number of payment years, also known as a period-certain annuity. Under that provision, if you—and your spouse, if applicable—die before the guaranteed payment period ends, the insurer pays the remaining funds to your heirs.

Generally, the more guarantees an annuity contract contains, the smaller your monthly payments will be.

An Annuity as Supplemental Income in Your Retirement Plan

Annuities may make sense as part of an overall retirement plan, especially if you are uncomfortable investing or concerned about outliving your assets. Before buying one, however, make sure you consider the following questions:

1. Will you use the annuity primarily to save for retirement or a similar long-term goal? If not, another investment may be preferable.
2. For a variable annuity, how would you feel if the account's value fell below the amount you invested because the underlying portfolio performed poorly? That can happen.
3. Do you understand all of the annuity's fees and expenses?
4. Are you reasonably confident that you can hold the annuity long enough to avoid surrender charges? Do you have other assets you could draw on if you faced an unexpected financial emergency?

You can also consult a financial advisor to help you decide whether an annuity, or another type of investment, is right for providing the money you need during retirement.

Sources + References

1. Financial Industry Regulatory Authority. " Fixed Annuities ".
2. Financial Industry Regulatory Authority. " Indexed Annuities ".
3. Financial Industry Regulatory Authority (FINRA). " Variable Annuities ".