Annuities Explained

Annuity Basics

An annuity is an insurance-based retirement product that can create a stream of income in retirement, somewhat like a pension. It’s a contract with an insurance company for which you pay a premium  — just like life or health insurance premiums — to receive regular payments over a certain time frame, potentially the rest of your life.

Receiving an annuity payout as a series of periodic payments, as opposed to withdrawing one lump sum, is referred to as annuitization. Not all annuity owners choose to annuitize their payments. Instead, they may keep their money in an annuity for a lengthy accumulation, or growth, phase and eventually withdraw it as a lump sum.

As insurance products, annuities protect against the biggest risk in retirement: outliving your savings. This insurance against living long is the mirror image of life insurance, which ensures that your dependents are financially compensated upon your death.

With an annuity, your benefit is in living longer and receiving more payments.

As I plan for my client’s retirement, I look at various financial products such as annuities, CD’s, stock and bonds and MF. I then ask many questions of my clients and based on their needs and goals decide which product best fits what they desire. As I sell many clients an annuity, I make sure they understand the different annuity types, the penalties, rates, taxation and riders that many offer. Many times, I will use different annuity products to ladder their portfolio and look at timings of distribution and income and tax level of my clients. I explain the different types of annuities and help them pick one that best fits their need. Planning in this manner helps them be educated in different products and diversify their portfolio.

Aamir M. Chalisa, MBA, LUTCF, MDRTGeneral Manager at Futurity First Insurance Group

Aamir M. Chalisa is the GM at Futurity First, leading Oak Brook’s top branch. With 30+ years’ expertise, chairs GAMA Global, driving diversity worldwide.

Types of Annuities

Annuities are a wide range of products, each with different features.

Differences Among the Types of Annuities

• The level of risk involved
• Whether you or the insurance company bears the risk
• Whether you’ll receive payments immediately or at some point in the future

The type of annuity that’s best for you depends on a number of factors, including your age, your risk tolerance and how soon you want to receive payments.

Fixed Annuities

Fixed annuities earn interest at a guaranteed rate for the number of years specified in the contract. Like all annuities, the growth of a fixed annuity is tax-deferred, which means you won’t owe taxes on the interest earned until you receive income or withdraw from the annuity.

Fixed annuities are considered one of the safest types of annuities for consumers. The insurance company assumes most of the risk associated with the contract because they guarantee your interest rate and return of principal.

Fixed Indexed Annuities

A fixed indexed annuity, also called an indexed annuity or fixed-index annuity, earns interest in two ways. First, there’s a minimum guaranteed interest rate, similar to a fixed annuity. However, an indexed annuity also earns interest based on the performance of a linked market index, usually the S&P 500.

These annuities carry some risk, as the exact returns are difficult to predict. The insurance company still assumes the risk of guaranteeing a return of principal and a minimum accumulation. Indexed annuity providers balance this risk by limiting the upside potential of indexed annuities, either by capping the maximum interest the annuity can earn or only crediting a percentage of the index’s gains as interest to the annuity.

Variable Annuities

Variable annuities don’t guarantee return of principal like other annuities. The value of a variable annuity contract is entirely dependent on the performance of an underlying portfolio of investments that the annuity owner selects.

Although principal protection and growth aren’t automatically guaranteed with a variable annuity, the vast majority of these products are sold with living benefits, riders that add on some form of guarantee at an extra cost.

Variable annuities are considered the most risky type of annuity. When you purchase a variable annuity, you, not the insurance company, bear the majority of the investment risk. Living benefits can transfer some of this risk to your provider, but you’ll pay additional fees for that risk transfer.

Immediate Annuities

The final type of annuity, and also the simplest, is a single premium immediate annuity (SPIA). Unlike the other types of annuities, SPIAs don’t go through an interest accumulation phase. Instead, the money you use to purchase a SPIA gets converted immediately into a stream of income.

SPIAs are considered very safe products since the insurance company guarantees your payments. The main risk of a SPIA could be that you pass away before you receive the full value of your annuity in payments. Some SPIAs don’t have death benefits, so if you die before your annuity fully pays out, the insurance company keeps what’s left.

Annuity Payout Options

Annuities turn a lump sum premium into income, and annuity owners can customize their contracts with a number of different payout options. Many of these options are based on the lifetime of a person called the annuitant. 

The annuitant may or may not be the annuity owner or the person who receives payments from the annuity; they are simply designated in the contract as the person whose lifespan factors into annuity payout calculations.

Annuity Payout Options

Single Life

One of the most common payout options, a single life annuity guarantees payments for the rest of the annuitant’s life.

Joint Life

A joint life or joint and survivor annuity guarantees payments for the lifetimes of both a primary and a secondary annuitant.

Life with Period Certain

A life with period certain annuity guarantees payments for a specified number of years or for the annuitant’s lifetime. If the annuitant passes away before the guarantee period, payments for the rest of the period will go to the contract’s beneficiary. If the annuitant lives beyond the guarantee period, payments continue for the rest of their life.

Period Certain

A period certain annuity guarantees payments for a specified number of years. If the annuitant passes away before the guarantee period, payments for the rest of the period will go to the contract’s beneficiary.

Lump-Sum Payment

When the annuity’s term is up, the owner can opt to receive the full value of their contract as a lump sum payment.

Systematic Withdrawal

With systematic withdrawals, annuity owners can select the amount and frequency of their income payments, which last until the annuity’s funds run out.

Annuity Customization Options

A key feature of annuities is the owner’s ability to customize their contract. Owners can select provisions called riders, which add benefits to the contract at an extra cost.

The Most Common Annuity Riders

Death Benefits

Not all annuity products come with a death benefit for beneficiaries, so this is a common type of rider. A death benefit rider might guarantee that the beneficiary receives the contract’s value at death, the initial premium less any withdrawals or whichever is greater.

Living Benefits

Living benefit riders are commonly added to variable annuities to make these products less risky for the annuity owner. A living benefit might guarantee a minimum dollar amount for the annuity’s payouts or allow the owner to withdraw a certain percentage of the principal each year.

Long-Term Care Rider

A long-term care rider guarantees increased payouts from an annuity if the owner requires long-term care services or is confined to a nursing home.

Cost of Living Rider

A COLA rider increases an annuity’s payouts by a small amount each year to adjust for inflation.

How To Buy an Annuity

You can buy an annuity directly from an insurance company or through a broker, financial planner or independent insurance agent. 

The first step to buying an annuity is figuring out what product you want. You should consider your financial situation and what you hope to get out of your annuity. 

If you work with a financial advisor, broker or agent, this person will likely ask you some questions to determine whether an annuity is right for you. In many states, the law requires financial advisors to adhere to certain suitability standards, only recommending products that are in their clients’ best interests.

Common Suitability Questions

• When do you hope to retire?
• What are your monthly expenses, including housing, food, utilities, insurance and transportation?
• How would you describe your health?
• If you had to guess, do you expect to live longer than average?
• How much do you expect to receive in monthly Social Security benefits?
• How much do you have in retirement savings? How much do you expect to have when you retire?
• Do you have a pension or any other sources of income? What is the monthly total you expect to receive from these sources?
• How much monthly income do you think you will need in addition to Social Security and any other sources of income?
• How would you describe your comfort level with investment risks? 
• Do you have any dependents? If so, how much do you need to budget for them?
• What do you hope to leave to your dependents?
• What expenses do you have now that you don’t expect to have in retirement?
• What expenses do you anticipate in retirement that you don’t have now?
• Do you need to make a provision in case you or your spouse might need long-term care?

You might also find it helpful to research what annuity rates are available and which reputable companies offer the product you’re interested in.

When selecting an annuity provider, look for companies with strong credit ratings. These scores are issued by independent rating agencies like AM Best, Fitch Ratings and S&P Global, and they represent how likely an insurer is to be able to meet all their obligations to customers.

AM Best is the most popular of these credit rating agencies. AM Best’s ratings range from A++, denoting Superior financial strength, to D-, which signals Poor financial strength. Most experts recommend only purchasing annuities from providers with an A- or better rating from AM Best.