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What Is An Annuity And How Does It Work?

Posted October 26th, 2011 in Insurance, Investing by Jeremy Waller
Annuity Cartoon

Comic courtesy of Lance Andrew

I listen to a number of podcasts from several different finance gurus. Over the past week I’ve heard people asking questions about annuties. The story usually goes something like this…

Caller: My financial advisor told me I should roll my IRA into an annuity. Is this a good idea?

Guru: No! It’s a terrible idea!

End of call.

Okay. The advice may be fine, but now that person (and everyone listing) has no idea why the guru thinks annities are evil. Most probably don’t even know what an annuity is or how one works.

Asking for advice on your finances is good, but understanding why someone gives that advise is better. All decisions regarding your finances should ultimately be made by you. And you can’t make a good decision until you understand what your choices are.

What Is An Annuity

A basic definition of an annuity is a stream of fixed payments over a specified period of time.

In the world of personal finance, an annuity typically refers to a product sold by insurance companies.

The basic concept is that you pay in a certain amount of money – over time or in one lump sum – and the insurance company agrees to pay out a certain amount over a period of time.

Depending on the type of annuity, the amount you receive may be the same each month or it could vary – payments could be for a set number of years or could continue until death – and at death, the remaining value will either be forfeighted or paid to a beneficiary.

Clear as mud, eh? Annuties can look quite different depending on what type they are.

Types of Annuities

At the most basic level there are 2 types of annuities – fixed and variable. These work just like they sound.

A fixed annuity pays a fixed amount each period. If you have a fixed annuity, you know exactly how much each payment will be.

Payments under a variable annuity change based on the performance of the underlying investments. When the investments do well, payments increase. When the investments perform poorly, payments decrease.

Variable annuities carry more risk, but there is the potential of a larger payout if the market performs well.

Annuities can also be classified as immediate or deferred. With an immediate annuity, you start receiving payments right away while payments under a deferred annuity are deferred to a later date.

Annuity Payout Options

The payout options available with annuities are typically what most people find attractive.

Income For Life

The income for life option is what sells most people on an annuity. They like the idea that they can just put money into an annuity and not worry about outliving their money.

With this option the insurance company agrees to pay you a certain amount each month until you die. It doesn’t matter if you live for 50 more years. The insurance company will continue to pay.

But what if you die next year? Then that’s it. No more payments. Your heirs receive nothing.

Income For A Guaranteed Period

With this type of payout structure, the insurance company promises to pay a certain amount each month for a certain period of time regardless of how long you live.

If you die before the end of this time period, your beneficiaries receive the remaining payments in the guaranteed period.

Joint and Survivor Annuities

This option is similar to an income for life annuity, but payments are guaranteed for the life of you and your spouse.

You will often find annuities with a combination of the options above.

Now why would you want to consider an annuity? Well, they aren’t totally evil despite what you might hear from some of the personal finance gurus. But, there are a lot of people that have an annuity that don’t need one. Or they’re investing in them the wrong way. I’ll dig into all of this in a post next week.

What’s your opinion onĀ annuities? Would you ever consider one as part of your own financial plan?

 

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4 Responses so far.

  1. My take is this…

    Social security works like an annuity and few would live comfortably with an income stream that doesn’t increase with inflation. I feel like variable annuities sort of defeat the purpose.

    • Jeremy says:

      That’s one of my beefs with fixed annuities – inflation can eat away your income stream. But, I guess that’s the price you pay for a guaranteed income stream.

      I could write a whole post on this. Actually, I am writing a whole post on this that will be live next week.

  2. Evan says:

    Annuities are a massively misunderstood insurance vehicle. It is easier to say “they are too expensive” then to truly understand how they protect an owner by removing market risk.

    Are they for everyone? No way. Just like a brokerage account filled with 100% equities isn’t right for everyone.

    • Jeremy says:

      I totally agree. Very very few financial products on the market are truly a bad deal for EVERYONE. Annuities tend to get a bad rap because they are a high commission product that gets sold to people who don’t need it. But it is a vehicle that does serve a purpose and can be a smart choice in certain situations.

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