What Is An Annuity? How Do Annuities Work When Retirement Planning

Not A Finance Whiz? Here’s The Simplest Explainer For How Annuities Actually Work

March 30, 2020 Updated June 23, 2020

how do annuities work
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Thinking of your golden years doesn’t just include dreaming about fun European bus tours or soaking up the sun at your timeshare in Florida. It also means planning for retirement and your financial future. After all, you will need to build the financial cushion that will fund your golden years, your children’s growing list of needs, future healthcare costs, and any unforeseen rainy days your family might encounter. It’s all very stressful, which is why so many people procrastinate. But no more.

Yes, here comes the boring part. Part of planning for retirement includes thinking about your plans  for the future and how you’ll be able to pay for them later (this is where a retirement calculator comes in handy). Some of those strategies include setting up a trust or a will, paying off debt, or putting an annuity into place. But what is an annuity anyway and do you even need one? Luckily, we’ve condensed the annuities FAQ and answers, below, should it be part of your plan for retirement.

What is an annuity?

If you like the thought of a steady stream of guaranteed income, then you will probably like the idea of an annuity. Essentially, an annuity is a structured financial product that provides a series of payments made at equal intervals. That’s industry jargon for payments you buy into that are paid out at intervals of your own choosing.

Annuities are created and sold by financial institutions, including insurance companies, and can be used towards retirement as well as for specific goals, such as principal protection, lifetime income, or long-term care expenses. While receiving a steady stream of income sounds pretty sweet, annuities are often confusing and misunderstood by many mainly because they’re often viewed as investments but are actually contracts. It’s always, always a good idea to consult a financial advisor you trust, and maybe even an attorney who can review the contract and make sure you’re getting a fair deal. You never want to buy into an annuity now and be surprised by a part of it when it comes time to start receiving payments.

How do annuities work?

Like other forms of insurance, an annuity works by paying a sum of money, akin to a premium, to an insurance agency either with a lump sum of money or in a series of payments. Unlike regular insurance, eventually you will stop paying your premium, and as a result of this contract, the company will begin to pay you a guaranteed income with interest. This is done in regular payments that you can determine. You can choose to receive your payments for a set number of years or for the rest of your life. You can also choose to receive your money in monthly, quarterly, semi-annual or annual payments. The income that you will receive is calculated at the time you buy your annuity and is determined by factors including the current interest rate and the number of years that you are expected to live. Once you purchase an annuity, your conditions are set in stone and cannot be changed. Which means you can’t dip into it sooner than you intend.

Why buy an annuity?

Most people will want to buy an annuity because of its promise of guaranteed income, which is why they’re popular for retirement planning. They might also allow you to become more adventurous with other investments since you already know to expect a set stream of income. Also, the money that you are investing is tax-deferred, which means you can pay into the annuity before you pay taxes and you also won’t be taxed on the annuity until you start to receive payments. It’s worth noting, though, that annuities often come with sales commissions, which means you’ll be charged a large fee that can be as high as 10 percent of the lump sum you’re depositing.

What are the fees associated with an annuity?

You know the old adage, nothing is free. And neither is setting up an annuity with an insurance company. There are administrative fees, investment fees, add-on fees, deferred sales-charge fees, mortality and expense risk charge fees, among others to consider when setting one up.

What to expect from a retirement annuity

Because annuities are designed to help protect you from the risk of outliving your income as well as to help cover your basic expenses in retirement, they’re perfect for those who don’t have pension plans and are looking for a financial option to replace income streams as they get older. However, it’s important to remember that the majority of annuities are not adjusted for inflation, which means you’ll receive the same amount of money at 60 that you will at 80. And once you pay into an annuity, you’re pretty much locked into it and you can’t even pass it onto a beneficiary.

Do open-ended life annuities ever run out of money?

That’s a loaded question. If you live longer than than the insurer expects, they run the risk of losing money with each payment. Which is why the annuity payments are set at such a conservative figure to begin with. If you pass away before the annuity has been paid out, however, you can name a beneficiary to receive the remaining balance.

How do cost-of-living adjustments work?

The good news is that you can include a cost-of-living adjustment clause when you’re drawing up your annuity and can use a predetermined percentage increase by year or base it on the rate of inflation. In the first scenario, say you choose a 2.5 percent cost-of-living adjustment, that means your monthly annuity payments will increase by 2.5 percent every year.

A adjustment based on inflation will protect your retirement annuity against rising inflation. Choosing this route will increase your annuity payments based on the current rate of inflation. If inflation is high, your payments will go up. If not, then your payments will stay the same.