How a Retirement Annuity Works

How a Retirement Annuity Works

An annuity is a contract with an insurance company, purchased with a lump sum or payments over time. The company invests the money and pays it back to the buyer in regular installments over time or in a lump sum at a specified time. Buyers should learn how a retirement annuity works and the fees and features that apply before selecting this type of financial product.

Learn the Different Types of Annuities

Generally, the three major types of annuities are:

  • Fixed annuities: The “fixed” parts are the guaranteed minimum interest rate and possibly the total number of payments the buyer receives. Although the insurance company can elect to pay a higher rate according to market conditions, they can never pay less than the guaranteed minimum rate. Unsurprisingly, that minimum rate is usually fairly low. Payments continue for a specified time, usually the rest of the buyer’s (also known as the annuitant’s) life. Some contracts may provide for continued payments for a surviving spouse’s lifetime. After that, however, if there is any money left, the insurance company keeps it.
    • An immediate fixed income annuity typically requires a lump-sum purchase payment, and the payouts begin immediately.
    • A deferred income annuity puts off the date when payouts begin and allows the buyer to accumulate interest and/or make additional payments or contributions over time, to increase the amount of money available for payouts upon retirement.
  • Variable annuities: These allow the buyer to select investment products, usually mutual funds, that may fluctuate in value with market conditions. Money grows when the market goes up but loses value during down times. Fees and expenses may apply depending on the investment products selected and can significantly reduce the value of the annuity over time. Variable annuities may have a death benefit option allowing the buyer to indicate who should receive any money that remains after the annuitant’s passing.
  • Indexed annuities: These are a hybrid product that may see part of the purchase money used for a guaranteed base of income, while the remaining portion’s performance is tied to that of an identified index like the S&P 500.

Fees, Rate of Return, and Time Value of Money

If the buyer chooses to invest money in a variable annuity, the funds and products available may charge management fees that pile up over time, reducing the amount available at retirement. Locking up a large amount of money in a fixed annuity takes away the opportunity to invest in other financial products that may have much higher rates of return that compound over time. If the buyer falls on hard times and needs to withdraw the money immediately, hefty surrender fees apply. Penalties apply for any money withdrawn from a retirement account prior to age 59 ½.

Other Risks

If the insurance company that sold the annuity goes under, so does the buyer’s money. Some states provide some protection but most likely won’t cover the full loss. To understand more about how annuities work and find one that may make sense for you, research annuity brokerage agencies. Before choosing a broker, confirm they are licensed and find out how they get paid by the companies offering the products they sell. Also verify that they comply with the “best interest” rule requiring them to act in the best interest of the annuity buyer.

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