A Beginner's Guide to Understanding Annuities

What is an annuity, and how do they work?

Man holding a question mark wondering what is an annuity.
What is an annuity? They are all different. Jon Feingersh

An annuity is an insurance contract. Many people think of an annuity as an investment, but when you purchase an annuity, you are buying an insurance policy. You are ensuring an outcome.

You put money into the insurance contract or policy, and the insurance company provides you a guarantee as to when and how you will get that money back, or what interest rate your money will earn.

There are about as many types of annuities as there are breeds of dogs, and each type works differently.

Because there are so many types of annuity products, this leads to a lot of confusion about what an annuity is and how it works. You may have also heard strong arguments for and against annuities, but the truth is that it all depends on what type of annuity you are talking about and what you are using it for.

Let’s look at the five main types of annuities you are likely to come across — immediate annuities, fixed annuities, indexed annuities, variable annuities, and deferred annuities — and see how each type of annuity works.

What Is an Immediate Annuity?

With an immediate annuity, you give the insurance company a lump sum of money, and they pay you a guaranteed amount of monthly income. They pay the income out either over a set time period, such as ten years (this is called a term-certain annuity), or they guarantee to pay you as long as you live.

Think of an immediate annuity that pays out over your entire life like a jar of cookies.

You give the insurance company your money (a full jar of cookies), and they hand you back a cookie each year. If the jar becomes empty, they promise to keep handing you cookies anyway, for as many years as you live. In return, you agree that once you hand them the jar, you can’t reach in and take a cookie anytime.

If one year you want three cookies, you’ll have to get them from somewhere else — not from that jar.

This unending supply of cookies means a life payout annuity is a good hedge against living a long time. No matter how long you live, and no matter how much of your other money you spend early in retirement, you’ll still get a cookie each year. For older single retirees, an immediate annuity can help make sure they don't outlive their money.

What Is a Fixed Annuity?

A fixed annuity is a contract with the insurance company in which they provide you a guaranteed interest rate on your investment. A fixed annuity works a lot like a Certificate of Deposit (CD) issued by a bank. Instead of the bank guaranteeing your interest rate, the insurance company is providing the guarantee.

With a fixed annuity, the interest accumulates tax-deferred. You pay tax when you take a withdrawal. The interest that is withdrawn before age 59-1/2 is subject to a ten percent early-withdrawal penalty tax, as well as ordinary income taxes.

The interest rate is usually guaranteed for a fixed amount of time, such as five years or ten years. After that time period is over, the insurance company will tell you what your new interest rate will be.

At that point, you can continue the annuity, exchange it for a different type of annuity, or (like a CD) cash it in and decide to invest the funds elsewhere. (If you cash it in, you will owe taxes on the accumulated tax-deferred interest.)

Most fixed annuities have surrender charges, so if you cash in the annuity early, be prepared to pay a hefty fee. A fixed annuity can be a smart choice if you want a low-risk investment, might be in a lower tax rate later when you withdraw the funds, and are willing to leave your funds in the contract for the required amount of time.

What Is an Indexed Annuity?

An indexed annuity is a type of fixed annuity that is often called a fixed indexed annuity (FIA) or an equity-indexed annuity. With this type of annuity, the insurance company offers a minimum guaranteed return along with the potential for additional returns by using a formula that ties the increases in your account to a stock market index.

Indexed annuities have complex features such as participation rates and cap rates that spell out the formulas for how your returns are calculated. Compare such features side by side when looking at this type of product. Consider this product as a CD alternative, not as an equity alternative. If someone proposes it to you as an equity alternative, think twice.

Some indexed annuities also have features that guarantee the amount you can withdraw later in retirement. This type of product is called a deferred indexed annuity, and it can be a good choice for someone about ten years away from retirement, as it guarantees the income they'll have in the future.

What Is a Variable Annuity?

A variable annuity is a contract with an insurance company in which you get to choose how the funds inside the contract are invested. The insurance company provides a list of funds (called sub-accounts) to choose from. It is called a variable annuity because the returns you earn will vary depending on the underlying investments you choose. Contrast this with the fixed annuity, where the insurance company is contractually providing you with a guaranteed interest rate.

Investments inside a variable annuity grow tax-deferred, so, just as within an IRA account, you can exchange between investments without paying capital gains taxes.

For the variable annuity to qualify as an insurance contract, guarantees must be provided. The most common type of guarantee is a death benefit guarantee which guarantees that upon your death the greater of the current contract value or the full amount of your contributions (minus any withdrawals) will be paid out to your beneficiary. For example, if you invest $100,000, and the investments went down in value to $90,000, and you passed away at that time, the contract would pay $100,000 to your named beneficiary. If the investments had gone up in value and were worth $110,000, the contract would pay out $110,000.

Today’s variable annuities come with additional death benefit guarantees and living benefit riders that make them one of the most complex consumer financial products I have ever seen. For investing purposes, index funds are often a better choice than a variable annuity. For the purpose of a guaranteed outcome, other types of annuities are better. That doesn't leave many situations where a variable annuity is a smart choice. Due to tax-deferral, a variable annuity might be an appropriate choice for a young high-income earner who is already maxing out 401(k) plans and IRA contributions and is looking for an additional place to put money where it can grow tax-deferred for 20 - 30 years.

What Is a Deferred Annuity?

With a deferred annuity, you deposit money today, and an income stream is guaranteed to start at a defined time in the future, usually at least ten years from the time you initially purchase the annuity. This type of annuity can help reduce the risk that a big downturn in the stock market would thwart your planned retirement date.

Many fixed, indexed, and variable annuities offer a deferral feature where you have the option to buy a guaranteed amount of future income. These features go by names like guaranteed withdrawal benefit, living benefit, guaranteed income riders, etc.

A deferred annuity may also be called “longevity insurance” and there is a special type of deferred annuity, called a Qualified Longevity Annuity Contract (QLAC) that you can purchase with your 401(k) or IRA money. With a QLAC, the income usually starts at age 85, so you buy this type of annuity to ensure that you will have a minimum level of income in your older age.

As you can see, all annuities are not alike. Any type of annuity can be a good choice if you know why you are buying it and how you will use it — and any annuity can be a bad choice if you don't understand how it works.