Annuities Explained: Definition, Types, Characteristics and How They Work

Annuities are a great financial tool for anyone who wants a predictable income stream, tax-deferred treatment, and asset protection. Understanding what an annuity is, who they're designed for, and the differences between the various types can be incredibly beneficial to your financial future. 

What is an annuity?

An annuity is a financial product usually offered by insurance companies designed to provide a reliable and steady income stream over a specific period or for the rest of your life. It's a contractual agreement between a person and the insurance company selling it. 

The person getting the annuity pays the insurance company a lump sum or periodic payments that are put toward their annuity. Once they've stopped accumulating money within the annuity, the insurance company will begin making disbursements from the annuity toward the annuitant (the person receiving the income).

Annuities can often be used as retirement tools for people looking to supplement their income after they've stopped working. There are different types, and each type is designed for someone with a different financial need, giving them a unique versatility that other investment vehicles don't always have.

Who buys annuities?

Annuities are typically purchased by people looking for long-term financial security. The primary characteristics of annuity buyers are:

• Approaching retirement: People nearing retirement or recently retired often find annuities attractive because of their ability to replace their income. While a pension and Social Security can help, an annuity can be another way to mitigate the risk of running out of savings during retirement. 
• Seeking stability and security: Those of us looking for financial security and stability frequently consider annuities as an investment vehicle that can provide just that. Annuities are a great way to guarantee regular income payments. Those income payments can help you handle bills such as rent and utilities, saving you from worrying about making ends meet at the end of the month.
• Wanting to obtain tax benefits: Annuities can offer tax-deferred treatment, a benefit anyone looking to grow their wealth is interested in. They can be a reliable way to grow your investment in a tax-preferred vehicle while you wait to retire.
• Looking to secure death benefits: Anyone wanting to secure funds for their beneficiaries may be interested in annuities, as they can offer death benefits for their holder. These benefits can protect the principal, or initial investment, and may provide a stream of income to beneficiaries for years.
• Willing to live comfortably with limited liquidity: As annuities may have distinct periods where you can't make a withdrawal, they can make for a good investment if you don't mind having limited access to your funds. They could be a great option for you if you're willing to contribute your funds into an annuity for a longer period. 

How does an annuity work?

An annuity works in two distinct phases: the accumulation phase and the aptly named annuitization phase, also known as the payout phase, each serving a unique purpose.

The accumulation phase

Several key steps define the accumulation phase:

• The initial contributions: You'll have to pay into your annuity before you can collect disbursements. The initial investment part of the accumulation phase is when you contribute funds into your annuity through a lump sum or periodic payments. 
• Growth of funds: The contributed money accumulates and grows while receiving tax-deferred treatment. The annuity may then grow within different investment options depending on the type of annuity — a fixed annuity will grow based on a stated fixed rate of interest, while a variable annuity could grow based on the performance of the underlying investments it's tied to.
• Potential additional contributions: Some annuities allow you to add more contributions periodically, adding to the growth of the initial principal contribution.
• Pre-retirement growth: This cycle will continue until the annuitant reaches retirement or their preselected date, giving the annuity time to accumulate contributions and potentially grow their wealth.

The annuitization phase

The annuitization phase is when you start receiving payments from your annuity:

• Conversion to payouts: The annuitization phase is when you convert your annuity into payouts, receiving a steady income on a predetermined basis. You can receive your annuity payments monthly, quarterly, or however your contract stipulates. 
• Payout options: Annuity holders can choose between a variety of payout options. They may receive a lifetime income stream or funds for a fixed period. Annuitants can also elect how to receive their payments. Most people prefer to receive a check in the mail or for their funds to be directly deposited into their bank accounts.
• Guaranteed, steady income: The annuity pays out in regular installments, which ensures a steady stream of income for the annuitant for the duration of the annuity. This can be for a specified period, such as 30 years, or the rest of the annuitant's life.
• Death benefits: The annuitant's death doesn't necessarily stop the annuity's payouts. Annuities can come with certain death benefits that entitle beneficiaries to continue receiving payments after the annuitant is deceased. This can be an attractive feature for someone who wants an investment that supports their loved ones after they die. 

Types of annuities

Understanding the different types of annuities and what they offer can help you make an informed decision when looking at ways to plan for your financial future. They all have certain characteristics that can give you a better insight into their purpose, benefits, and who they work best for.

Other characteristics of annuities

• Immediate vs. deferred annuities: Immediate annuities start paying out income payments within a year of their purchase, whereas deferred annuities delay income payments to a later date, giving the investment time to grow before distributions begin.
• Single premium vs. flexible premium annuities: Single premium annuities are initially funded with a lump sum, usually just once. Flexible premium annuities allow you to make periodic contributions over a longer period. This can be better if you want more flexibility when contributing to your investments.

Deciding if an annuity is right for you

Deciding if an annuity is right for you depends on your financial goals and retirement plans. There are different types of annuities, each suited to people with different risk tolerances, income needs, and long-term strategies. 

For anyone looking for long-term stability and security from their annuity, fixed annuities might be the best choice. They come with guaranteed returns, giving you the foundation to enjoy retirement. Variable or fixed index annuities might be better for those willing to receive more market exposure for potential upsides.

Immediate annuities are great for someone looking for an immediate payout, while deferred annuities may work better for someone with more time to let their investment grow. There are also single premium annuities where annuitants can fund their contract with a single lump sum or purchase a flexible premium annuity and pay over time.

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