Annuities are a popular retirement planning tool, though they may be the result of a legal settlement, too. These complex legal contracts are often confused with investment accounts like IRAs and 401Ks. While there are similarities, there are many differences, as well. But if you are confused about how annuities actually work, know that you’re not alone. And that’s why we’re here to explain what annuities are and how they work.
What Is an Annuity?
Annuities are an insurance contract. They traditionally paid an annual sum every year as agreed upon in the contract. Annuities could be designed to pay out for ten years or the rest of your life. Annuity contracts have become more complicated as investment options have exploded. That is why you could arrange for a fixed annuity or a variable annuity. In the latter case, the money is invested in the stock market but you’re guaranteed a set rate of return.
How Do Annuities Work?
Annuities must be funded before the insurance company can dole out the annual payments. The person typically made several lump sum payments or one large payment with the insurance company. The insurance company has to pay the money back to the person, their family or their beneficiaries as promised. Whether this is a set amount for the next thirty years or an amount that varies based on stock market returns and interest rates depends on the contract you sign.
The annuity money is generally invested by the insurance company to generate returns. They keep the profits. If you’ve signed up for a variable rate annuity, they will pay a sum based on the returns that year, but you won’t see the same returns as if you’d invested the money in the stock market. The insurer pockets the profits. On the other hand, they’re guaranteeing a minimum rate of return. This ensures that you get at least a certain amount of money each month. This guaranteed payment regardless of how the market does provide more security and stability than you would get if you’re withdrawing three percent of the 401K every year. When you turn on the annuity and start receiving payments, this is called annuitization.
When you start receiving the annual payments from the annuity depends on the type of annuity you chose. With a deferred annuity, you contribute the money to the annuity but agree not to touch it for a given length of time. You could roll your old 401K into the annuity while agreeing to leave it alone for at least ten years. This gives the money time to grow, and this typically results in higher payouts later on. Some people make regular payments to the annuity in place of contributions to a retirement account. Unlike tax-advantaged retirements like a 401K or IRA, there is no contribution limit. You can also contribute to an annuity in addition to these types of retirement accounts. Others simply roll their pension payout into the annuity so that they don’t have to try to manage an investment portfolio.
What Are the Different Types of Annuities?
The fixed annuity is the simplest form of annuity. You sign the contract and deposit the money. The insurer locks you into a fixed interest rate for a given time. For example, you might be promised a 3% rate of return. You’re guaranteed to get a certain amount of money, but you’ll miss out if the stock market soars.
Indexed annuities were created to try to resolve this problem. You choose one or more marketing indices. The money is invested in these markets. Your payments are based on the performance of the index. There is generally a floor set by the contract. For example, you may be guaranteed at least 2% return. That ensures that you have income coming in even if the market suffers a downturn. You pay for it in the form of a maximum rate of return. The insurance company uses some of the money they receive when stock market returns are above the maximum rate to make payouts in down years.
Variable annuities are the most complicated type of annuity, and they have the highest level of risk. You can choose from a list of investment options. Unlike indexed annuities, the annuity can lose value. In a worst-case scenario, you don’t receive a payment at all, depending on the annuitization payout structure.