How Annuities Work

Annuities are term deposits with insurance companies.  They are similar to certificates of deposits at the bank (note: bank deposits are FDIC insured while annuities are guaranteed by the issuing insurance company).  There are two types of annuities: fixed annuities and variable annuities. Fixed annuities have these features:

 Your principal is guaranteed, it will never decline
 The insurance company adds interest to your deposit each year
 The annuity is for a specific term that you select—generally, the longer the term, the higher the interest
 All interest is tax deferred (you do not report it on your tax return) until withdrawn
 You may withdraw 10% of your balance annually
 If you withdraw more than 10% during the term, you will pay withdrawal penalties (called surrender charges)

Most fixed annuities offer an initial one-year rate with the rate changing each year.  A few companies offer a locked-in rate for the entire period.  We recommend that investors always get a locked-in rate.  Fixed annuities are the safest, most conservative choice.  In this short description of how fixed annuities work, we have not covered the many permutations--each annuity company's contract is different so read it thoroughly. The annuity calculator will give you an idea of the amount you can accumulate.

Next, let's consider how variable annuities work. With variable annuities, rather than receiving interest from the annuity company, your money is invested into stock or bond accounts (these are investment accounts like mutual funds).  You may earn more or you could lose principal, depending on the accounts you select and if the stock and bond markets rise or fall.  Variable annuities are the riskiest choice.

Maybe the best choice is an index annuity as it is a "hybrid" of a fixed annuity and variable annuity. With an index annuity, your principal is guaranteed like the fixed annuity, but your interest each year is based on increases in the S&P 500 index (this is an index based on 500 large stocks, such as IBM, General Motors, Intel, etc).  So, your interest you earn is tied to performance in the stock market but you can never lose principal (unless you withdraw your principal prior to the end of the term and pay surrender charges).  You get the guarantee of a fixed annuity with the potential profit of a variable annuity.

Everything discussed about how annuities work up until this point describes the growth phase (called the accumulation phase) of the annuity.  When and how do you get your money out? Here's how annuities work regarding the accumulation phase and you generally have three options:

 You can leave the annuity alone and continue to let it grow
 You can exchange the annuity to another company that may pay you a higher rate
 You can start to make withdrawals

The withdrawal phase is called the distribution phase.  You have three options:

 You may withdraw all of your money at once
 You can withdraw some money each year based on your desires
 You can annuitize the policy

Annuitizing means that you accept fixed monthly payments from the annuity company.  The payments can span your lifetime or be limited to a specified period (e.g. 10 years).  At the end of the period you select, the annuity is completely paid out.  If you select a lifetime payout, the payments will continue for as long as you live.

As you might imagine, the monthly payments are usually more for a fixed 10-year payout than if you select a lifetime payout (the option which pays the most depends on your age).

Annuitizing may or may not be a good deal and depends on your circumstances.

If you are single and need to maximize your monthly income, the lifetime annuity payments may be a very good deal.  On the other hand, if you want to leave money to your heirs, annuitizing would not be good because there will be nothing left at the end of the annuitization period.

What is an immediate annuity?

An immediate annuity has no accumulation phase.  You make a deposit with the insurance company and immediately begin receiving payments.  These annuities are generally suited for senior investors (age 70 plus) who desire to increase their monthly income.  You can see how much you get using the immediate annuity calculator.

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