“Annuity” immediately calls to mind another word: retirement. 

That’s because the vast majority of annuities are bought by people who are planning for retirement and want a regular source of income after they stop working. They are setting themselves up to receive a regular source of income after they stop working.

Many American adults either draw from an annuity, or will someday. Social Security, with more than 45 million people receiving benefits, is a form of annuity. You pay into the system during your working years, then receive payments when you stop.

But according to the Federal Reserve Board, retirees know they need more than Social Security. 

In a May 2020 report, the central bank indicated fewer than 40% of non-retirees thought they were saving enough for retirement. And data from the U.S. Labor Department show that only 55% of adult civilians have a retirement plan with their employer.

Annuity basics

Annuities are similar to individual retirement plans: they are a way for individuals to build a nest egg. Like Individual Retirement Accounts and 401(k) plans, annuities are self-funded: you put money into the plan over time, the money is invested, and the nest egg grows. IRAs, 401(k)s, and annuities all have 10% penalties for funds withdrawn before age 59 1/2.

Unlike other retirement plans, annuities are insurance contracts that include obligations. You must make a certain amount of scheduled premium payments over time to fund the contract. The insurer then invests the premiums, and when you retire it begins sending you monthly checks as your annuity income. With IRAs and 401(k) plans, it’s your choice whether to put money into them.

How do annuities work?

The annuity contract has a life cycle, in two phases: the accumulation phase and the distribution phase.

• Accumulation phase.

  This is the period when the holder is paying premiums to fund his annuity—he is “accumulating” money for retirement. It starts when the contract is signed and runs to the time he decides to start receiving annuity income. This period can run for decades, depending on how early in life the holder buys the annuity and how much he wants at retirement.
  

• Distribution phase

  . This is when the holder begins receiving income—when the annuity funds are being “distributed” back to him. The phase can last for a set period, say 10 or 20 years, or until the holder dies, depending on the terms of the annuity contract. If the holder named a beneficiary or heirs and he dies before the annuity is fully distributed, then payments may continue to the beneficiary, or a lump sum payment of the balance be paid to the heirs. In the absence of a beneficiary or heirs, the issuer keeps the balance.
  

Types of Annuities

Insurers, banks, and mutual-fund companies sell most annuities as scripted plans for retirement income years ahead, called deferred annuities. They come in three main types:

1. Fixed annuities

Fixed annuities are the simplest. The name stems from the annuity’s focus on fixed rates. The issuer invests the annuity holder’s premiums in government bonds and highly-rated corporate bonds, known in finance as fixed-income securities. The annuity holder later gets monthly income payments at a guaranteed rate established in the contract. The issuer’s goal is to get a return on bond investments, for example, of 3%, and pay the annuity holder 2%, profiting from the difference.

Because it’s the simplest, with the least risk involved, a fixed annuity generally has lower costs than other annuities.

2. Variable annuities

A variable annuity lets the holder invest in a combination of private mutual funds created for the issuer, called sub accounts. This allows for possibly higher returns when markets are rising, and bigger payouts later when the annuity holder starts receiving monthly checks. Returns and payouts may suffer if markets decline, however.

Fees for variable annuities are higher, as the issuer must manage a riskier assortment of investments. They can easily total 3% of assets and go higher if the annuity holder adds options to the contract such as inflation protection or a rider for long-term care.

3. Indexed annuities

As the name implies, indexed annuities are tied to some market index. It offers a rate to the holder based on the index’s rate of return, with an important limitation: The holder doesn’t get the full return.

Let’s use the Standard & Poor’s 500 Index, the leading benchmark in U.S. stock markets. For 2020, its simple price return, excluding dividends, was 15.8%. Indexed annuities typically use two contract provisions to limit the gains to the holder:

Participation rate. In plain English, this is how much you’re allowed to enjoy the index’s return. Let’s say the participation rate is 60%, meaning you get 60% of 15.8%, or 9.5%. Some annuities allow a higher participation rate, others lower.

Rate caps. Most indexed annuities also impose an upper limit on the return to the invested funds. This can be in addition to the participation-rate limit. In the above case, the annuity may have a cap of 8%, further pulling down the return from 9.5%.

Example of an annuity

Here is an example of how an annuity is calculated:
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A 35-year-old middle manager works at a company with a traditional defined-benefit pension plan and earns $75,000 a year. He’s concerned that the plan may not be adequately funded and that his pension payment won’t be sufficient when he reaches retirement age. Also, he may change jobs in the next 30 years. So he is thinking about an annuity to ensure enough retirement income.

This person would like to receive $5,000 from the annuity when he turns 65. An insurance agent gives him this calculation:
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This is the total after 30 years of premiums, invested at 5%. Now the agent does a calculation of how much monthly retirement income this would produce at age 65:
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This assumes 20 years of benefits beyond retirement. If this person only lives for 10 more years and wants the annuity compressed into 10 years of payments, the monthly annuity would rise to $9,060.20.

More importantly, this basic calculation doesn’t account for the sales commission and other costs of an annuity. A joint survivor annuity, a death benefit, or any other added provision to the contract costs more, affecting the accumulated principal or estimated monthly annuity payout.

Benefits of annuities

Annuities can be an attractive option for generating retirement income for the following reasons:

1. They can provide a reliable income stream during retirement.
   

2. They relieve anxiety about living too long and money running out—what the insurer calls longevity risk. The insurer manages the investment of the annuity funds and accepts the longevity risk.
   

3. There’s no limit to how much you can pay in premiums to fund the annuity. An IRA is limited to $6,000 contributed annually or $7,000 if you’re 50 or older. Employee contributions to a company 401(k) plan are a maximum $19,500 or $26,000 if 50 or older.
   

4. Deferred taxes. Like IRAs and 401(k) plans, annuities aren’t taxable until the holder begins receiving income payments.
   

5. Death benefit. An annuity holder can designate a beneficiary or heirs for any unused portion of the annuity fund, either as continued monthly payments or as a lump sum.

Drawbacks of annuities

Despite the many benefits of annuities, investors should also watch out for the the following disadvantages:

1. Annuities have high fees and sales commissions compared with mutual funds and exchange-traded funds (ETFs) that are widely used in IRAs and other plans. The sales commission alone can run from 2% to 10% of the contract value; typically it’s about 4% to 5%. Other insurance and investment fees can run a few extra percentage points
   

2. Loss of control and access. Your money is locked up for a long time. The issuer doesn’t want you interrupting the accumulation phase when it’s investing your premiums, building your targeted nest-egg before it must begin paying out your annuity. To deter you, the issuer will charge a steep surrender fee on invested premiums if you want to withdraw money during the accumulation years or cancel altogether. The fee starts at about 10 % in the contract’s first year and gradually descends in subsequent years.
   

3. Unlike contributions to an IRAs or 401(k), which are tax-deductible, most annuities don’t qualify for this tax status because they aren’t part of employer-sponsored retirement plans. (The SECURE Act, enacted on Jan. 1, 2020, includes a provision to allow 401(k) plans to offer annuities.) Even so, it may be smarter to contribute to the IRA or 401(k) first, before buying an annuity with after-tax dollars.
   

4. You’ll have to be satisfied with relatively low rates of return. The annuity is a trade-off: you get peace of mind from the guaranteed monthly income when you reach retirement age, in return for modest growth of your investment as you near retirement. That’s because the annuity issuer is managing your longevity risk. For that risk, it charges you the fees that reduce your returns, and  investment choices generally will be limited to lower risk assets such as bonds and the issuer’s own private mutual funds.
   

5. Annuities aren’t easy to understand. There are many types, with different provisions and costs. And because they are contracts, you will be held to them. Read an annuity contract carefully before you sign anything, and seek professional advice.

Are annuities a good choice for retirement?

In a nutshell, annuities can be a good choice for certain people, such as:

• Those with low tolerance for risk and the ups and downs of financial markets
• Those with no interest in managing their money or monitoring their investments
• Those with a high degree of personal financial discipline, as a deferred annuity requires years of uninterrupted premium payments
• Retirees who want to flow some personal wealth into a guaranteed stream of income as they age and are less able to manage their wealth. They could create an annuity with one large lump-sum premium payment, and begin receiving monthly income immediately.