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How Does an Annuity Work?

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If you’re a baby boomer or work for a government agency, you may still know about pensions. As a public school teacher I paid in to the State Teachers Retirement System of Ohio and if I would have taught for 30 years, I was guaranteed a certain percentage of my highest paying year.

Not much is guaranteed anymore and that’s why pensions are largely a thing of the past but there’s a product on the market that can give a person pension-like benefits as they head in to retirement. It’s called an annuity. Annuities are insurance products that guarantee you a certain amount of income once you retire. Here’s what you should know.

Quick Facts about Annuities

  • Most annuities are sold and marketed by insurance companies.
  • They are designed to guarantee a certain income once you retire.
  • The money you pay in to the annuity is invested which is what allows for the guaranteed payout.
  • They may come with a lot of fees.
  • There are a lot of different kinds of annuities.
  • Investment income generated by the annuity is tax free until you begin drawing on the annuity.

Annuity Terms You Should Know

Fixed vs. Variable

A fixed annuity guarantees a certain payout regardless of investment market conditions. A variable annuity delivers a payout based on the performance of your money. Variable annuities often have higher fees and expenses than fixed annuities.

Immediate vs. Deferred

An immediate annuity allows you to receive payments soon after you open the account. Deferred annuities put off the payments until you reach retirement age.

Sub Accounts

If you have a 401(k), you’re already familiar with sub accounts. In basic terms, each mutual fund you pick for your variable annuity is a sub account. The value of your annuity is based on the collective value of your subaccounts.

Payout Options

Your annuity comes with a variety of ways to pay you. A period certain annuity pays for a specified amount of time. If you outlive the payout period, you receive no more payments. Lifetime payments will pay out until you pass away but surviving beneficiaries receive no further income from the annuity.

Married couples often choose a payout with a survivor benefit. This requires the annuity to continue paying until both spouses pass away.

Positive vs. Negative

The positive side of annuities is apparent. We don’t know what retirement will bring as far as our health and our ability to generate an income so knowing that we are guaranteed an income is a big selling point. The problem with annuities are the large fees that often come with these products. Broker commissions and annual fees could a seriously degrade a person’s nest egg.

How to Purchase

After you’ve done your homework. (Here’s a more detailed series on annuities) look at annuities from investment companies instead of insurance companies. These often bypass broker commissions and sell direct to the customer. One of my favorites is the Vanguard annuities. They advertise that their fees are 75% less than the average annuity. Other investment companies also have annuity options worth comparing.

 Bottom Line

Annuities aren’t easy products to understand. If you need help, look for somebody who will give you advice on different options but won’t sell you the annuity. This avoids a conflict of interest. Guaranteed retirement income is a great thing as long as you don’t pay hefty fees and expenses to get it.

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10 Responses to “How Does an Annuity Work?”

  1. I didn’t know that annuities were quite this complex. I was looking into these as a place to sock away some cash in retirement to get at least one guaranteed income stream, but maybe I should just concentrate on our retirement accounts…

  2. Robert says:

    Timely article. In the middle of restructuring some of my parent’s estate and they have several annuities. Reading them, I find they are quite complex. It seems all of them have at least 5 to 7 ways to withdraw the money and each of the withdrawals seem to benefit the Insurance Company in some way. Even though I think I am somewhat savy, I am going to have to engage the services of a Financial Planner to determine the best way to withdraw the money for Taxes and to yield the Greatest Return on Investment.

    They have enough other Income coming in to cover all of their expenses and then some. But they are in their 90′s, in good health and want to put the money that is invested in annuities to good use. And all of the annuities were purchased within the last 7 to 15 years.

    One seems to be funding a Long Term Care Policy and I am finding that confusing as all get out. The issuer of the Policy has not been much help. The funding annuity originating from the same company that is providing the LTC Policy.

    • Frugal says:

      Robert,

      When you meet your advisor, plesae go over the Long term care and annuity scenario & understand them properly. I am in the insurance industry and it may not be wise to cancel everything.

      May I suggest checking with your parents and/or their advisor? I am sure there was a good reason to do it this way. Just understand and then validate the reasons. If they are no longer true or scenario has changed, action is good.

      Many times, it is much more difficult to obtain similar coverage with the new policy.

      • Robert says:

        Frugal,

        Thank you for your response and tips. At this time, I am not going to change anything and most likely it will be some time until any action needs to be taken.

        We are working with an Elder Law Attorney at this time and am going slow.

      • Robert says:

        Frugal,

        Wanted to add that cancelling the LTC is out of the question at this time.

        One parent has Alzheimer’s and is at stage 4 out of 6 for that condition and the other had a mild stroke that impacted some cognitive abilities.

        We are trying to have them age in place, but who knows what the future holds? I am certain that the LTC will be used, though, at some time by both.

  3. Zach @ DSO says:

    Annuities are fine for people that want a set it and forget it guarantee. I obviously prefer a more active approach through dividend investing. My biggest problems with fixed annuities is the limit on what my money can earn. And yes the fees are nothing to be happy about either.

    I almost qualified for a pension when I worked at Fannie Mae but I didn’t put in enough years there. They like many other companies no longer offer that benefit.

  4. mjac522 says:

    Annuities do have fees and do pay an agent a commission but that does not make them bad products.

    There are fees involved because annuities are an insurance product. You are insuring your money against market risk and longevity risk.

    Some annuities will let you draw a pension based on a guaranteed rate of return. For example, if you invest $100,000, the insurance company will let you annuitize based on that $100,000 earning 6% per year. This is regardless of actual investment performance. So if the market tanks and your annuity is only worth $50,000, you still draw an income based on the much higher amount.

    If you have put together a nest egg and you are trying to figure out how much to draw each month as an income, the annuity solves that issue. It also guarantees you will never run out of money. No other product can offer that.

    It is very easy to focus on the fees associated with annuities but you really need to take an honest look at both sides of the coin. They have their benefits and drawbacks just like every other financial/insurance product.

  5. Fabclimber says:

    Two things to consider regarding annuities.

    A. There is no guarantee that the insurance company you gave your money to won’t go broke.
    This is important if you are putting much of your retirement money in that one annuity.

    B. If you have an annuity contract where the money passes to your beneficiary, the earnings are taxed at the beneficiaries rate, not the rate of the owner. True also for the principle if it was an untaxed roll-over when deposited.

    • Frugal says:

      “A. There is no guarantee that the insurance company you gave your money to won’t go broke.
      This is important if you are putting much of your retirement money in that one annuity.”

      You are correct with that statement. However, if the insurance company goes broke, similar to insurance contracts, annuities are also “protected” by the state insurance department. Normally, the Ins. Dept steps in and takes over the Company and slowly liquidates the Company, if cannot be rehabed, by selling the existing business to other companies. The policyholder/annuitant is protected with the original contract.

  6. Derek says:

    Once you annuitize, you no longer own the lump sum, but rather you own an income stream. You are giving up the whole for a guaranteed income for a certain period of time (per the particular contract). I, like many, do not like losing control so have avoided annuities where possible. They are complex and need to be dealt with very carefully. Great Post!


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