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How Do Annuities Work?

With so many products, accounts, and options available, creating the right retirement plan requires research into a variety of options and deep understanding of the potential benefits. Annuities are one potential retirement income source. Learn what they are, review the different types of annuities, and discover how they work.

What Is an Annuity?

An annuity is an agreement between a person and their insurance company. Many people choose to use annuities as a form of retirement planning. The purchaser provides payment to the insurance company either in a lump sum or in recurring payments during their working years, and in exchange, the insurance company takes that money and invests it. In retirement, the insurance company provides regular payments, usually monthly, for the rest of the purchaser’s life. Annuities come in many different forms with varying levels of return and risk, so understanding the differences between the different types of annuities is vital.

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Types of Annuities

Annuities come in a variety of forms, which impact the potential payout during retirement and the associated risk. Annuities can take one of three basic structures:

Fixed Annuities

Insurance companies set an interest rate when creating the annuity in a fixed annuity. The rate of return (and the payments) do not change regardless of market volatility. Purchasers can choose to begin their payments immediately or defer until necessary. Fixed annuities ensure that the purchaser receives a set and consistent income each month if used for retirement.

Variable Annuities

Variable annuities are tied to the stock market. Purchasers choose which funds they want to put their money into, which impacts how much they receive each month in retirement. Purchasers take on more risk with a variable annuity, but the chance of reward, or higher payments each month, increases with the level of risk. Variable annuity payments can and will vary from month to month depending on the stock market.

Indexed Annuities

An indexed annuity is a combination of fixed and variable annuities. Part of the purchaser’s investment is put in a fixed account, guaranteeing a certain amount per payout. The rest is put in investment accounts of the purchasers choosing, increasing the chance that they’ll receive more income each month. Indexed annuities ensure the purchaser receives a low-set amount each month, with the potential for a higher additional payout depending on how the stock market performs.

How Does an Annuity Work?

Annuities are a type of investment. They help individuals structure payments to ensure they’ll have enough money to live on. Payments are made at set intervals, usually monthly. While annuities can provide payment at any time, most people choose to begin payment after they retire for the rest of their lifetime. The word “lifetime” can mean different things depending on the type of annuity selected. Some purchasers opt for a specific number of years while others stipulate payments continue exclusively for the remainder of their life.

Purchasers who choose a set number of years can pass payments on to a spouse or other beneficiary should the pre-set payment term exceed the purchaser’s life. However, the inverse can also happen, in which the purchaser outlives their policy.

Selecting a payment term for an unspecified period of time equal to the length of the purchaser’s life ensures that they’ll have enough money to live on indefinitely, but does not ensure payments after life to a spouse or other beneficiary as the payments will cease upon death.

When Should You Get an Annuity?

Annuities, while most commonly associated with retirement income, can be used for a variety of purposes. Since an annuity is a type of investment, purchasers can use them for other sources of income or savings. The most common uses for annuities are building retirement income, safely managing lottery winnings, and structuring other lump-sum income.

Retirement

Annuities are most often used for retirement savings. Purchasers might choose an annuity over other types of investing later in their work-life, as the risk levels are low, particularly with a fixed annuity, and the payouts are consistent. Generally, experts recommend maximizing other forms of retirement savings, like 401(k)s or IRAs before getting an annuity. Often, these retirement accounts provide greater returns than an annuity. However, unlike other retirement accounts, annuities do not have yearly contribution limits, so you can add more to an annuity account than you could to an IRA. In this case, payments usually begin after retirement.

Lottery

Lottery winners usually get the choice of receiving their winnings in a lump sum or through annuity payments. Annuity payments help lottery winners manage their sudden influx of earnings by providing dependable, consistent payments over a period of time rather than an immediate influx of cash. An annuity is certainly something to consider for lottery winners concerned about long-term savings. In this case, the lottery winner usually begins payments immediately regardless of their work status.

Other Lump Sums

People may receive large lump sums of income from other sources, such as an inheritance. Annuities can be used to safely structure payments of that lump sum, much like with lottery winnings. Some people in this situation choose to begin payments immediately while others keep the money for post-retirement income.

Other Considerations

People thinking about using an annuity should consider the following factors:

  • Insurance company: The annuity’s payout depends on the health of the insurance company that holds the money. That means if the insurance company faces hardship and can’t cover the payouts, then the annuity’s purchaser might not receive their money.
  • Upfront fees: Annuities often come with quite a few fees, including costs like commissions, investment management fees, and insurance charges.
  • Low return: Annuities are low-risk investments, but that means they’re also low return. Investors might make more back long-term by putting money into other types of investment accounts.
  • Withdrawal costs: Withdrawing money from an annuity can come at a cost. Some accounts have penalties for removing money prior to a certain age or over a certain limit in a set time period.
  • Other investment options: Depending on the needs of the purchaser, other investment options might be suitable. Reviewing every choice is wise before making an investment decision.

Understanding how annuities work is vital in selecting the appropriate investment or retirement plan. Annuities can help users structure consistent payments and ease financial worries in retirement.

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