How Do They Work, Types And More

If you’re nearing retirement, one of the most important (and potentially stressful) questions you have to ask yourself is “do I have enough?”

One-third of Americans over 50 said their biggest retirement planning regret was not obtaining a lifetime income source, according to a Nov. 2022 study from researchers at the University of Pennsylvania and the Hebrew University of Jerusalem. 

One way to help maintain a regular income during retirement is by buying annuities. These are complicated products that can come with high fees, but CNBC Select explains the basics so you can decide if annuities are worth a closer look.

An annuity is a contract between an investor and an insurance company. The investor, known as the annuitant, pays either a lump sum or a series of payments to the insurance carrier in exchange for guaranteed income payments, which can begin immediately or in the future. You can buy an annuity from insurance companies, banks, brokerage firms and online issuers.

Insurance companies invest your initial payment, exposing that lump sum to the market and allowing it to increase over time. Depending on the issuer and the type of annuity, your initial payment may be invested into stocks, bonds or money market funds.

At its core, an annuity can guarantee consistent payments back to the investor, which means you can potentially have guaranteed income for the rest of your life. This is why annuities are typically used to subsidize retirement expenses. 

The biggest risk with retirement planning is outliving your savings, as you don’t know how long you are going to live, says Elle Switzer, the director of annuity product management at TruStage. “When you think about retirees of the past, many of them had pension plans from their employers, and, through that, they had a guaranteed income stream that doesn’t exist for most of us anymore,” she says.

Granted, an annuity payment alone may not be able to cover all of your monthly expenses, depending on the plan and how much you paid upfront. But the fact that annuitants can get consistent payments until they pass away makes them worthy of consideration for your retirement planning.

Here’s a snapshot of an annuity’s lifetime: 

1. You, the annuitant, choose an annuity type based on your retirement goals.
2. You purchase that type of annuity plan through an insurance company.
3. The insurance company invests your initial payment.
4. Your annuity account earns interest from these investments.
5. You elect to begin receiving payments from the annuity. 
6. You are paid back your original investment plus interest (minus the insurance company’s fees).

The time during which your investment earns interest is known as the accumulation phase. The time during which you receive payments is known as the annuitization phase. Depending on the type of annuity you are investing in, your annuitization phase may begin immediately.

Unless your annuity plan has contractual withdrawal amounts, you usually can’t access the money until your payout period begins, and in other instances, you may be charged a penalty for withdrawing money before the end of your surrender period — the duration of time during which you cannot withdraw funds from the annuity. 

Most annuity surrender periods are between two and eight years, but some can last as long as 10 years. Still, even if your surrender period has expired, you will receive a 10% IRS penalty if you make a withdrawal before age 59½.

When you reach your payout period, you’ll likely begin receiving monthly payments as you would from a pension or a paycheck during working years. Any interest earned on a deferred annuity won’t be taxed until you make a withdrawal. This allows your investment to grow even faster.

You can legally opt-in to these payments any time after your surrender period is up. However, if you do so before age 59½ you’re going to encounter that 10% additional tax penalty. Most financial advisors recommend leaving these annuities untouched for a while and start receiving payments in your late 60s or early 70s. Like most long-term investment accounts, it’s generally a smart idea to leave them alone and allow them to generate as much interest as possible, making your payments higher when they begin.

If you’re interested in calculating your potential annuity payout, Charles Schwab offers a helpful Income Annuity Estimator.

Annuity investment returns depend on a number of factors, including the performance of the index it’s invested in, the cap on potential interest it can earn, the type of annuity and more. But you can usually expect to see a 4% – 6% annual return on some annuities and as much as an 8% annual return on others. So, if these investments are left alone for extended periods, they can be extremely lucrative in retirement.

Different types of annuities have varying levels of risk, but annuities as a whole can typically withstand economic downturns. Of course, every investment comes with some sort of market risk, but you can reduce that risk by adding a rider to your annuity contract (for an additional cost), which can protect you from the losses of the annuity investment underperforming.

These benefits can make annuities a safer investment than owning common stock for example, but the more lucrative your annuity’s benefits (or riders) the more expensive your annuity’s fees will be.

Do you pay fees on annuities?

An annuity fee is an additional cost associated with purchasing an annuity. These fees are usually deducted from the balance of your investment. Annuity fees typically run between 1% and 3% of your account’s balance annually. 

The types of fees you encounter depend on the company you purchase the annuity fee from. Some companies, like USAA, charge no upfront fees except the 10% IRS penalty for those who make withdrawals before age 59½. Some companies charge fees that may be administrative, like commission fees and maintenance fees.

Make sure you understand and are financially prepared for the fees associated with an annuity before purchasing it. The more complicated an annuity, the more expensive its fees are. For example, a variable annuity, which requires more investor oversight, will typically cost more than a simple fixed annuity.

However, the most common fees are charged for optional benefits called annuity riders.

What is an annuity rider?

Annuity riders are like add-on benefits that can be purchased and are separate from the base contract that you sign when you take on an annuity. By paying an additional fee, you can eliminate some of the risks associated with annuities and make them a more attractive investment.

Switzer says examples of annuity riders include

• An enhanced death benefit: This could make your contract pay out the maximum of its value when you die. 
• A guaranteed minimum income: This prevents your income from dropping below a certain threshold regardless of what type of annuity it is. This rider might guarantee that you will receive a payment based on the value of your initial investment compounded at 6% interest annually, at minimum, or it might guarantee that you receive a payment based on the highest market value that your investment ever achieved.
• A guaranteed lifetime withdrawal benefit: This allows you to have access to your account value at all times, bypassing a deferral period and letting you use your annuity account as an emergency fund. 

Certain companies offer other benefits like long-term care riders that match payments for medically required long-term care, a cost-of-living rider that adjusts your payments for inflation, or an impaired risk rider that can essentially fast-track your annuity payout should you be given a life-shortening diagnosis. 

It’s important to remember that (in general) the more value a rider adds to your annuity, the more expensive it will be.

Annuities come in many shapes and sizes. Some are purchased as a one-time payment, and some are purchased through a series of payments. Annuities also vary in how they pay out, with some giving you a lump sum while others make a series of payments. 

Evan Potash, an executive wealth management advisor at TIAA, says there are two general categories of annuities: immediate annuities and deferred annuities. 

• Immediate annuities are opened with a lump sum investment and result in immediate, guaranteed income payments. These are sometimes referred to as income annuities. These are smart investments for late savers or those close to (or already in) retirement, since they start paying out immediately. However, unlike deferred annuities, they don’t have as much time to accumulate interest, so payments are usually lower.
• Deferred annuities, by contrast, have a deferral period that focuses on wealth accumulation before payout. This is the most common category of annuities, especially for those saving for retirement. This allows your capital investment more time to accrue interest, resulting in higher payments than an immediate annuity would. Think of deferred annuities like a private form of social security. And unlike immediate annuities, these annuities usually offer a death benefit, which transfers your remaining assets to a beneficiary should you die before the end of the annuity contract. However, deferred annuities have long surrender periods, making your investment non-liquid usually for two to eight years.

Regardless of whether an annuity plan is immediate or deferred, Potash says an annuity can be structured in one of three ways: as a fixed, variable or indexed annuity. Some companies, like Fidelity, offer all three types of annuities and have financial advisors who can help you choose which is best for you.

What is a fixed annuity?

A fixed annuity is one that delivers you payments with a flat rate of return, regardless of inflation or market changes. While fixed annuities provide peace of mind and typically have little-to-no fees attached, they usually don’t pay out as much money as a variable annuity. 

What is a variable annuity?

A variable annuity gets invested in stock funds that typically keep pace with inflation – think real estate or bond funds. With variable annuities, you can assume that these investments will keep your cash as valuable as or more valuable than it was when you first invested it. 

With this type of annuity, you run the risk of the market going down and your monthly payment decreasing. While you will contractually receive payments for life, they may decrease substantially, and it may take decades for your payments to equal your initial investment.

“You’re not going to run out of money, but it can continue to go lower if the market continues to go lower,” says Potash. “But over the long term, if you look at markets, they tend to go up much more than they go down.”

If you opt for a variable annuity, you should have a backup plan or a flexible budget so you can still afford all your expenses in case your payouts decrease over time.

What is an indexed annuity?

An indexed annuity is one that is invested in indexes, like the S&P 500 or the Dow Jones. Because these stocks represent a considerable number of America’s top companies, they generally reflect the economy as a whole. Like a variable annuity, an indexed annuity is designed to keep pace with inflation and secure your purchasing power for life.  

But indexed annuities are not foolproof. You’re likely to have lower returns than you would with a fixed annuity should you encounter a bad market year, as your investment is exposed to an index stock or index-linked bond. However, this type of annuity usually guarantees that the least amount of interest you can earn annually is 0%. So if the index goes up, you’ll earn a percentage of those gains and if the index goes down, you may not earn anything — but you also won’t lose any of the money you put in the annuity.

You don’t have to be planning for retirement for annuities to be a good idea. Though some annuities have $100,000 buy-ins, some have a low minimum initial investment of $5,000. The higher your investment, the higher your monthly payments, generally speaking.

For example, consider a 40-year-old woman who invests $100,000 into an annuity to be left untouched for 20 years at an annual rate of return of 8%. According to Bankrate’s annuity calculator, her monthly payments will be around $830. Under the same circumstances, an annuity with a $5,000 initial investment would yield monthly payments of around $41.55.

There’s no perfect age or perfect money market for buying an annuity. Switzer and Potash agreed that annuities can be a smart idea for newly working savers building financial independence, though they’re not a great idea for people who need fast and easy access to cash. CNBC Select recommends having your other financial ducks in a row before investing in annuities. It’s more important to establish an emergency fund, max out employer 401(k) contributions and reduce high-interest debt before considering tying up your cash into this kind of investment.

Make sure to read and understand all the information and terms associated with an annuity before purchasing it. Not only can taking the time to understand your annuity protect you from a bad deal, but it can also help you get the most value out of that annuity. 

Switzer says annuities are best as one component of an entire retirement portfolio, and you should not invest everything you have saved into annuities. 

“Annuities can really just be another investment vehicle, and it’s an investment that has some guarantees, and that can work very well for some people,” says Switzer.

Investing all of your retirement savings into annuities leaves you with a lump sum of potentially interest-accruing value, but you can’t access a majority of it at once. If you encounter a financial emergency and need lots of cash quickly, you will likely be out of luck. 

Potash recommends having about a third of your savings readily accessible and about two-thirds of your money in a guaranteed account of some kind, like an annuity, pension or social security.

What other options do I have for retirement?

There isn’t one right way to fund your retirement. Depending on your employer, your income and your lifestyle, you have plenty of options for smartly saving for your golden years. 

Employer-sponsored plans include 401(k) and 403(b) accounts, which are tax-advantaged retirement plans. Roth 401(k)s are slightly different, as they’re an employer-sponsored after-tax plan. 

Individual plans include IRAs, Roth IRAs and simple IRAs. These investing tools allow individuals to earmark their retirement savings by making individual contributions. These plans are not tied to your employer, so anyone can open an individual retirement account. Further, you don’t have to pay taxes on withdrawals from Roth IRAs since you’ve paid taxes upfront.

For unsure retirement investors, CNBC Select recommends robo-advisors like Betterment and Wealthfront, which allow you to indicate factors like risk tolerance, time horizon and financial goals so the platform can invest your money in a portfolio that aligns with your needs. These platforms make it easy to invest your money on auto-pilot and prepare for retirement in a hands-off manner.

If you are self-employed or work freelance, you should consider an SEP (simplified employee pension) plan, which may also have provisions for guaranteed lifetime income. 

You could also consider investing your money in a high-yield savings account or investing in stocks and bonds.

Regardless of how you prepare for retirement, you should still maintain cash reserves separate from investments. Having a diverse portfolio, one that includes a sure-fire cash tap, is always a smart approach to retirement.

Annuities offer retirees another steady income stream to help keep them financially secure and comfortable. Make sure you fully understand the terms of an annuity before purchasing it as an annuity can only be a useful tool when you understand its limitations. 

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