Pensions Retirement

What is an Annuity? How Do They Work? Here’s Our Complete Guide

An annuity is a type of insurance providing the holder with a guaranteed stream of income over a nominated period
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You might understand the details of opening a checking account or a certificate of deposit, but what about annuities? As someone learning to be an astute investor, you need to understand the advantages of including an annuity in your portfolio.

An annuity is a type of insurance providing the holder with a guaranteed stream of income over a nominated period. Receiving a guaranteed income stream for life is something that should pique the interest of any investor. So, why doesn’t everyone own an annuity?

Annuities are complex contracts that include many requirements and terms that might make them unattractive to some investors, especially if you self-insure. There are dozens of different annuity types, each with various options, disclaimers, footnotes, riders, and contingencies that you need to understand.

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What Are the Different Annuity Types?

You get two classes of annuities; deferred and immediate. What’s the difference between the two?

Deferred Annuity

Those investors that are still decades away from retirement can benefit from a deferred annuity. A deferred annuity allows you to secure a guaranteed income stream during your retirement years by opening an account with a financial institution.

The cash you stack away in your deferred annuity grows on a tax-deferred basis, meaning that you receive payments at a later date, and you need to pay tax on your contributions when you start to draw down on the annuity.

Deferred annuities come with multiple options, including; single or flexible premiums, fixed or variable annuities, life income annuities, joint annuities, and equity-indexed annuities, to name a few of the offerings available to you.

Immediate Annuity

For those that need a guaranteed income stream immediately, the immediate annuity is your best option. With this vehicle, you get the option of receiving a lump sum or splitting your payments into monthly, quarterly, or annual payouts. You have the option of receiving payments for a fixed term or until you die.

Options for Your Annuities

There are a variety of options with both deferred and immediate annuities. Check out the differences below when settling on your choice for the right annuity for you.

  • Single premium – Use a lump sum to purchase an annuity.
  • Flexible premium – Pay the insurer multiple payments to secure your payout later when you retire.
  • Fixed – The money in your annuity earns a fixed interest rate, regardless of changes in economic conditions.
  • Variable – The money in your annuity receives an allocation to multiple investments that could rise or fall, depending on the market’s performance.
  • Equity-Indexed – The financial services provider links this annuity to a stock index or another financial index. Your money grows in line with the performance of the assets making up the investment portfolio controlled by the financial services provider.
  • Life income – With this annuity, you receive an income for as long as you remain alive. This annuity continues to pay, even if you end up receiving more than you pay into the vehicle.
  • Joint and life income – Provides you or your partner with an income stream as long as one of you remain alive.
DIY Annuities Vs Commercial Annuities, Source

What Are the Advantages of Owning an Annuity?

When signing up for your annuity, there are two benefits that you need to take into consideration, tax-related and investment-related models.

Running Out of Money in Retirement

The average life expectancy of Americans continues to improve as medical science advances technology that overcomes disease and keeps us alive. Unfortunately, this situation presents a few new problems for retires – what if you run out of money before you die? Trying to find a job at 80 or 90-years old is impossible.

Annuities offer retirees a pragmatic solution to ensure they can fund their retirement properly. By selecting the right annuity, you have a financial vehicle that continues to pay you an income, regardless of how long you live.

Control Your Risk

A variable annuity helps the investor take risks with their money to grow their account balance, while still providing guaranteed payouts during retirement. As a result, you can take a risk like an investor, while still getting the benefit of a payout, even if things go wrong with your investment.

Tax Deferral

When buying a deferred annuity, all of the earnings in your account come tax-deferred, meaning that you don’t pay any tax until you start making withdrawals on your account. Since most seniors are in a low tax bracket, they don’t have to worry about paying excessive taxes on their money when they are in the prime of their career and part of a higher tax bracket.

No Limit on Contributions

Both 401(k) plans and IRAs have limits on the contributions you can make to the account each year, as set by the federal government. However, with an annuity, there are no set limitations on your contributions to your investment during the year.

What is an annuity?
What is an annuity? Source

What Are the Fees Involved with an Annuity?

Annuities might sound fantastic, but you need to be aware that this financial vehicle also comes with some disadvantages as well. Most of the cons involved with owning an annuity come in the form of fees. Let’s unpack the fees you can expect to pay when taking out and running an annuity for your retirement.

Expense and Mortality Fees

The M&E fee is one of the most expensive costs you’ll encounter when setting up your annuity. Financial firms can charge as much as 0.5 to 1.5% of the value of the policy in M&E fees each year. This fee helps the insurer cover the risk of you living longer than they expect.

Contact Fees

Some insurers charge this fee as an expense ratio, while others charge it as a fixed dollar amount. If you take out a high-value annuity, then the insurer might waive this fee.

Management Fees

The insurer will charge you a management fee for your account. If you’re using an annuity that involves an investment strategy, like an index annuity, then you can expect to pay management fees like you would with your IRA.

Rider Fees

You have the option of adding riders to your annuity as well. You get options like guaranteed living benefits or long-term care insurance. Each of the riders comes with an additional fee.

Broker Commission

When purchasing your annuity through a brokerage, the broker charges you a fee for facilitating the deal. Commissions can range anywhere between 1 and 10%, depending on the broker and the type of annuity you buy. As a benchmark, the longer the surrender period, the higher the broker commission.

Surrender or Withdrawal Fees

These fees describe penalties imposed by the insurer should you decide to withdraw or surrender your policy earlier than the set date. Penalties can be anywhere from 10 to 30% of the total cash value of your annuity, and the penalty amount differs from insurer to insurer.

What are the Disadvantages of Owning an Annuity?

The extensive fees involved with opening an annuity are enough to scare off plenty of investors. However, the fees are only one part of the puzzle of determining your annuity costs. Here are some disadvantages involved with taking an annuity.

Social Security is an Annuity

The Social Security Administration provides an annuity for all employees that pay payroll taxes for longer than 10-years. For those employees that are still working, you own a deferred annuity with your Social Security. Those people over 65-years that start making withdrawals from their Social Security accounts own an immediate annuity.

Lower Levels of Liquidity

Annuities provide investors with a guaranteed income stream when they retire. However, your part of the deal is that you lock-up your money with the insurer until you retire.

Therefore, if you encounter financial problems before your retirement date, you’ll take a considerable penalty hit on the value of your payout. As a result, there’s less liquidity in this asset, and you’ll need to wait until your retirement date to access the funds.

Annuity Tax

When it comes time to cash in on your annuity, you’ll have to pay income tax on your monthly, quarterly, or annual payouts. However, the deferred tax payments mean that you only need to pay tax based on your current income tax bracket.

Most people reach the highest tax bracket in their careers during their 40s and 50s. After retirement, your income drops substantially, and so does your tax bracket.


Annuities are not transparent assets. In most cases, they’re a complicated insurance product, and you could spend hours studying your insurer’s contract, and still not understand what they’re doing with your money.

Is an Annuity the Right Choice for You?

If you’re not using any of the tax-free investment options available to you, such as a 401(k) or Roth IRA, then don’t bother with applying for an annuity. Roth IRAs and 401(k) plans come with many tax advantages, and lower fees.

If you max out your contributions to your IRA or 401(k) for the year, then you can consider opening an annuity as a separate savings and investment vehicle.

You Don’t Mind Paying for Your Pension

For those people with decent retirement savings and investments, as well as low expenses, then the thought of having a pension for your retirement might sound appealing. Speak to a financial advisor to find out if it’s a sensible financial decision to allocate part of your savings to an annuity.

Overcome Financial Distress

If you already own a 401(k) and an IRA, but you don’t think you’ll have enough in your account to fund your retirement, the stress might keep you up at night. Opening an annuity is a practical option to boost your retirement income and ease your financial fears.

You Think You’ll Live Longer than Expected

If you have concerns that you might live longer than your retirement savings, then an annuity is a great way to safeguard you from running out of money. At this stage, it’s important to note the differences in annuity types, and you’ll need to choose one that suits your requirements.

Tips for Buying an Annuity

An annuity is like any other contract you sign or investment account you open – You need to fully understand the terms and conditions of the agreement before you sign.

The consumer protection board does put systems in place to prevent financial lenders and insurers from taking advantage of you. However, the onus of responsibility will fall on you.

Make sure that you understand every term and clause in the contract before you sign and start making payments to your annuity account. Once you commit to the contract, it’s a legal, binding document, and you must meet your financial obligations to the insurer.

Wrapping Up – Hire a Financial Advisor

When navigating through the investment environment, it’s a wise idea to get advice from people that know more about investing than you. We recommend that you look into hiring a competent, experienced, and qualified financial advisor., A financial advisor helps you adjust your finances to help you achieve your retirement goals.

A financial advisor might cost you a fee for their advice, but hiring them will save you plenty of time, money, and hassle when selecting your investments. However, make sure you’re working with an independent financial advisor. Many will work for companies, and receive kickbacks for recommending specific product offerings from their company.

An independent advisor is your best option for detailing a financial plan that’s independent of any influence from financial firms or insurers. An independent advisor will point you in the right direction when it comes to choosing the right annuity to suit your financial position and retirement goals.

The terms and conditions involved with an annuity are complicated, and a professional financial advisor can assist you in understanding everything before you sign on the dotted line.

Overall, annuities do have a place in your investment portfolio. Annuities offer investors and retirees another income stream that can help them live through their retirement comfortably, without the fear of running out of money.

Further Reading


Oliver Dale is Editor-in-Chief of MoneyCheck and founder of Kooc Media Ltd, A UK-Based Online Publishing company. A Technology Entrepreneur with over 15 years of professional experience in Investing and UK Business.His writing has been quoted by Nasdaq, Dow Jones, Investopedia, The New Yorker, Forbes, Techcrunch & More.He built Money Check to bring the highest level of education about personal finance to the general public with clear and unbiased

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