Annuities Explained: How Does an Annuity Work?

Aug 9, 2010
Carol Finch

Annuities Explained: How Annuities Work - Photo by nkzs

Annuities can play a useful part in the retirement asset allocation process by providing additional income streams. How does an annuity work?

In some countries annuities are used as the primary way of creating retirement income. In the U.S., these investments are more likely to be used as part of a broader asset allocation strategy. Some will, for example, buy an annuity when they have reached limits on other savings vehicles such as 401(k)s and IRAs. How does an annuity work and when might it be a good idea?

What is an Annuity and How Does it Work?

An annuity is a type of insurance policy that is designed to pay out an income and/or lump sum payment. Payments are generally set up to be made at specified points in the future, making these products a popular way of creating income in retirement. Basically, the individual invests cash in a product with the aim of converting the investment into cash at a later date.

How are Annuity Payments Made?

The cash/income made by the insurance company will depend on the original deal. Some annuities will give regular payments (i.e. monthly, quarterly or annually); some will give the option of lump sum payments. The length of time that an investment will provide income may also vary. Some products will pay out for life and some for a specified number of years.

Types of Annuities Explained

An individual looking to invest in an annuity has a range of product types to choose from. The choice made here can impact on how much return on investment is given. Options can include:

Fixed annuities (giving a guaranteed payout).
Variable annuities (giving payouts that can go up or down depending on investment performance).
Equity indexed annuities (giving a mix of guaranteed and variable payouts).

The option chosen may be based on the risk that an individual is willing to take. A fixed annuity is a safe option but may not give the highest returns. A variable product may come with higher payouts in some market conditions but may also pay out less. Equity indexed solutions combine security with some risk.

Is it Worth Investing in Annuities?

Many of those that invest in annuities will do so once they have reached their limits on other retirement savings options (i.e. when maximum contributions have been made to 401(k)s and IRAs). These products can be a useful way of investing spare cash as they are given tax-deferred status. This means that only earnings and not contributions are taxed.

This is, however, a long-term investment. Taking money out of an annuity early can result in high surrender charges. Individuals may also be charged commission and management fees so these are worth considering before choosing annuities as a retirement planning solution. Keep in mind that payout rates may vary so comparing products is also always a good idea.

Those interested in learning more about annuities and other ways to save for retirement may find the following articles useful:

Source: CNNMoney.com (" Annuities "). Accessed online 9th August 2010.