Let's talk about a topic that's been buzzing in the world of retirement planning lately: annuities. According to the trade association LIMRA, total U.S. annuity sales rose 22% to $77.5 billion in the second quarter of 2022. This was the highest quarterly sales ever recorded since LIMRA began tracking this data.¹  

If the term “annuity” sounds complicated, don't worry—we're here to break it down in the simplest way possible. Below, we talk about what annuities are, how they work, and what kind of role they might play in your retirement planning.

What is an annuity?

An annuity is a financial product designed to provide a regular, guaranteed income stream over a specified period or for the rest of a person’s life. Essentially, it's a contract between you and an insurance company in which you make a lump-sum payment or series of payments (premiums). In return, you receive a series of regular disbursements (payments) that begin either immediately or at some point in the future.

There are three participants involved in an annuity contract:

• Owner: The person who buys the annuity and pays the premiums
• Annuitant: The person, usually the owner, who is entitled to receive the annuity payments (and whose age and life expectancy are used to calculate benefits)
• Beneficiary: The person who receives the death benefit when the annuitant dies (e.g., a surviving spouse)

Annuities are typically used as part of a retirement strategy to ensure a steady flow of income during one's post-employment years. They’re often an option for workers whose employers do not offer pensions.

Annuities are sold by insurance companies but can also be obtained through a bank or brokerage firm.

How do annuities work? 

Below is a basic overview of the process of setting up an annuity contract:

1. Participants select an annuity type and pay into a plan purchased through an insurance company, bank, or broker. 
2. The insurance company invests the payment from the annuitant, so the account earns interest on top of the original amount invested for the duration of the contract. 
3. Once the annuitant decides to receive payments from the annuity, payments will be made up of a return of the original investment plus interest, minus fees. 
4. The annuitant receives income during their retirement period. 

In considering an annuity, it is important to understand that the money you invest (other than contractual withdrawal amounts) is usually not accessible until the annuity payout begins. In addition, you may be charged a penalty if you take your money out early, if you're not yet 59½ (additional 10% tax penalty), or both. 

What are the different types of annuities? 

There are several types of annuities to choose from. Before selecting, consider your financial goals for the future, the timeframe for when a payout is desired, and the fee structure. An outline of the different annuity types is below:

• Immediate annuity: Payout starts shortly after a single premium payment is made.
• Deferred annuity: Payout starts at a set date in the future. 
• Fixed annuity: Payout is based on an amount guaranteed in the contract. Payments are normally fixed, and the insurance company bears the investment risk. 
• Indexed annuity: This provides a guaranteed return with the option of sharing in investment market earnings. 
• Variable annuity: With this annuity option, accumulation and payout are variable and not guaranteed, although contracts may offer minimum guarantees as an option at an additional cost. There are also fees and charges to consider with this annuity type, including mortality and expense, contract fees, administrative fees, and the cost of the underlying investment options.

When looking at purchasing a variable annuity, you should keep in mind that variable annuities are long-term investment vehicles designed for retirement purposes. They will fluctuate in value. All investing involves risk, such as the potential loss of principal.

How are you taxed on an annuity?

Taxes are applied to an annuity when the money is paid out; the money is not taxed while it is in the account. The delayed taxation may help account values grow more than if they were subject to ongoing taxation. Annuities vary widely by terms, fees, structure, payouts, penalties, and possible (or acceptable) changes—allowing for customizable plans. A fixed annuity is one of the most predictable financial investments with guaranteed payments and duration. 

If the plan is originally purchased with funds that are not taxed (such as a 403(b) plan), all distributions are taxable. Consult a tax advisor for more information on the structures and implications. 

Are annuities a good investment?

Annuities may be good for people that want the option of a lifetime income during their retirement years—and who may have concerns about outliving their savings. There are other factors that should be taken into consideration before getting an annuity. Annuities are designed to be a long-term component of a financial plan along with other retirement income streams (subject to the claims-paying ability of the issuing insurance company).

However, annuities can be costly. They have standard fees that vary from company and by annuity type. Fees cover administrative costs and mortality expenses. In addition, there may be withdrawal fees if payments are taken before the predetermined period. Make sure you have a clear picture of the overall costs before purchasing an annuity. Since everyone’s financial situation and needs are unique, it’s best to talk to a certified financial advisor if you’re considering purchasing an annuity. 

I'm an older adult and have additional questions about annuities. Where can I get more information?

If you need help sorting through your financial options, NCOA's partner offers complimentary access to a team of specialists who are here to listen and learn about your unique financial needs. After discussing your goals and concerns, your specialist will provide personalized information and guidance to help ensure you're protecting your future. Get started by contacting a licensed professional today.

Sources

1. LIMRA: Second Quarter Annuity Sales Shatter Record Set During the Great Recession. July 21, 2022. Found on the internet at https://www.loma.org/en/news/press-releases/2022/limra-second-quarter-annuity-sales-shatter-record-set-during-the-great-recession/