How Do Annuities Work? Everything You Need To Know Is Here
Simply put, annuities are insurance contracts. They imply collecting and depositing a certain amount of money that, over the course of time, turns into a lump sum or stream of income you can use.
But how do annuities work?
If you’re wondering about the process itself – you’ve clicked on the right article.
Here are some of the questions we’re going to tackle today:
- How do fixed and variable annuities work?
- Who regulates annuities?
- What is the difference between annuities and life insurance?
- Can you lose money in an annuity?
If you continue scrolling, you’ll find the answers to these – and many more – questions.
How Do Annuities Work?
Annuities work on the principle of transferring the risk from the owner to the insurance company. That’s the basis – however, you need more than this brief overview.
Annuities are a type of insurance befitting people in their years of retirement. Their purpose is to save the owner from the fear of running out of assets.
The main point is that many people believe that the money on their savings account may not be enough, so they turn to insurance companies to buy an annuity contract.
The Concept Of Annuities
The basic concept of annuities declares that:
You buy an annuity with either one upfront payment or commit to a sequence of annuity payments to your insurance company. Once it’s done, the insurance company provides you with either a lump-sum payment or an income stream of payments throughout your retirement years.
The amount of payments depends on the annuity you opt for, the periodic payments you make, and other surrounding factors.
These so-called “financial products” are made fit for investors (annuitants) that are aiming at a stable and guaranteed payments, but most importantly – financial security! What’s more, this financial product is prone to “withdrawal penalties”, so it’s not recommended for younger users or those with liquidity needs.
What Are The Two Phases?
The annuity process consists of the accumulation and annuitization phases.
- The accumulation phase applies to the time period during which regular payments are being made or premiums that are being paid on insurance products that are meant for a retirement plan. The duration of this phase is usually specified at the time the contract is created, or when you decide to withdraw funds.
- The annuitization phase applies to the time when the payments start from the investment period. These are payments that provide the recipient (the annuitant) with a steady stream of income. It’s also called the “payout phase.” The size of the payments depends initially on the annuity and its value.
It’s also important to note that annuities can be deferred and immediate.
The difference between the two is personal finance. A deferred annuity is usually purchased by a person that receives a lump sum of money, while someone who purchased an immediate annuity agrees to a tax-deferred basis which will provide the annuitant with a steady income in the future.
Types: Fixed, Variable, And Indexed Annuities
From our previous articles and your own knowledge, you might be aware of the three main types of annuities – fixed, variable, and indexed.
If you’re considering buying one, the first step would be to become aware of the differences, benefits, and risks that each of them carries.
While we’re at it, what is the difference between annuities and life insurance?
First off, both life insurance policies and annuities provide the individual with an opportunity to invest on a tax-deferred basis. However, they don’t work on the same principle.
Annuities collect payments up to a certain point, and then set a life-long stream of income, ensuring the individual has a safe financial future. On the other hand, life insurance companies are tied to death benefit – which is a payout made to the beneficiaries after the insurer passes away.
How Do Fixed Annuities Work?
Fixed annuities ensure the annuitant a guaranteed income.
They are the most straightforward type of annuity investments. This makes them a good potential investment for someone who is looking for life-income and low risk. This type of annuity is considered to be the most reliable one, and has the lowest contract fees.
Fixed annuities work on the principle of you paying a steady stream of income, and the insurance company guarantees a significant plus and at a minimal interest rate. This simply means that this type of annuity pays an income for a fixed period of time.
As we said, there are two phases to annuities, and while the annuitization phase is on-going, the payouts will continue to grow at a fixed rate. In certain situations, the annuitant’s life expectancy isn’t long enough to claim the full amount of the annuity, so they have the opportunity to transfer their funds, and the surviving spouses can withdraw the money.
It should be emphasized that, if you’re considering of buying a fixed annuity, you have the opportunity to discuss the price with the financial product, which again, depends on the financial institution selling annuities.
Fixed Annuity: The Two Types
There are two major types of fixed annuities: life and term-certain annuities.
With life annuities, there is predetermined amount of money that is paid to the annuitant up until the time of their death. Contrary to this, term-certain annuities pay a monthly amount until the product expires, which can be before the annuitant’s death.
Apart from the agreed monthly payments, you can choose to receive a lump-sum of money.
How Do Variable Annuities Work?
A variable annuity is connected to the value of the investment portfolio. Accordingly, payments are bound to increase if the investment strategy is well-planned and the portfolio performs well.
This is a contract between you and the annuity provider, and in some cases, insurance companies. Basically, the annuitant purchases the ability to receive an income for life, but on a set period.
Once you purchase this annuity, the cash is then allocated to the portfolio, and you’re presented with multiple ways of investing methods. The most common ones include bonds, stocks and money market funds and so on. Besides mutual funds, the annuitant has the opportunity to invest in a fixed account that is characterized by a fixed rate, of course.
Does The Insurance Company Guarantee Income?
With these annuity, most insurance companies guarantee a return premium, or ROT for short. This ensures that you won’t use the primary money that you invested.
If you’ opted for deferred annuities, you won’t begin receiving payments right away. You will begin to receive payments after a year or so has passed from your purchase. This is also one of the aspects which makes this type of annuities suitable for someone who is not afraid of an investment risk.
It’s also important to note that, with variable annuities, you have the opportunity of investing money in a fixed-account. The interest rate might change, but this can provide guaranteed income with a minimum interest rate.
How Do Indexed Annuities Work?
With an indexed annuity, the return rate depends on the stock market index.
Although indexed annuities have set potential gain and losses, they are considered a less risky initial investment as opposed to most variable annuities.
These annuities provide you with a steady retirement income. But before you opt for these annuity products, you must first fund a contract. In the contract, the following will be spelled out:
- The method of receiving payments from your retirement account
- How much money you can withdraw
- When you can begin to withdraw money
How Do Equity Indexed Annuities Work?
With these annuities, the amount of money the company invests in your annuity is based on the index that you set. Equity indexed annuities have proven to be a safer choice of investing because the insurance company and investment professionals can protect you against possible losses.
Your losses and gains are characterized by fixed limits. Here, you have the minimum guaranteed return, guaranteeing a minimum income. Then you have the loss floor, which represents the maximum amount that you can lose. On the other hand, return caps represent the most that you can earn. The participation rate denotes the percentage of indexed returns.
This insurance product is best for someone who wants to invest their money in the stock market, but is still afraid of loses.
With indexed annuities, you’re most probably going to need the help of an Investment Advisor. This is a professional or a group of people that offer investment recommendations. They are also regulated by the SEC.
Who Regulates Annuities?
The next question follows the regulation and the qualified professional who regulates it.
So, who regulates annuities?
Annuity contracts are regulated by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC). Agents that deal with these contracts and sell annuities are required to have state-issued life insurance.
They don’t do it for free, though. These agents earn a certain commission percentage based on the notion value when you purchase annuities.
What Is A RICP?
On a similar note, you should start looking for a Retirement Income Certified Professional (RICP). This is a licensed professional whose main compartment is income retirement planning.
Basically, these are qualified professionals who assist and advise people during their retirement years and those who are near on the best way to use their funds and assets and provide them with a safe financial future.
What Is A CFP?
A certified financial planner specializes in the formal segment of any kind of financial planning, taxes, real estate, insurance, and retirement.
The main goal of CFPs is to help individuals manage their finances. This includes all types of assistance, starting with investment and retirement planning, education on insurance charges, and so on. These people are certified to make financial decisions in your best faith.
Unlike Investment Advisors, they are wide-ranging. They start off the process by deeply and thoroughly investigating your finances (cash, investments, assets, properties). After they’ve done so, they try to figure out and state your net worth.
They’re particularly good if you’re slowly reaching your retirement years, and you’re in need of a secure financial plan that will come into play once you start your retirement. But it’s not always connected to retirement; your child or grandchild that is going to college soon could also benefit from your ROTH IRA.
How Much Income Do Annuities Pay Per Month?
It’s time to put these words into concrete numbers. Let’s say that you purchased a life annuity once you turned 65 and agreed on monthly payments.
A generous $100,000 annuity would pay the beneficiary $527 per month for the rest of your life. However, if you die and there’s still some funds left on your account, they can be transferred to your surviving spouse, for example – that’s the joint-life annuity.
Why Are Annuities A Bad Idea For Some?
Annuities can represent a bad idea for someone. Here are the most common reasons why people decide to back down and not buy an annuity of any kind.
- These are all long-term contracts with pending penalties.
- Certain annuities bring annuitants little to no interest at all, and they carry risks.
- There is a chance that an annuity doesn’t provide a death benefit for surviving beneficiaries.
- You have to wait until you turn 60 to withdraw money from your annuity.
- Although income is guaranteed, the annuity often can’t keep up with inflation.
Remember an annuity is nothing more than a personal pension. We’ve successfully provided you with an all-encompassing answer to how certain types of annuities work and the aim of annuity providers. You’ve been able to grasp the full idea of how much financial protection these annuities provide, the amount of investment management fees, and the purpose of retirement savings.
The point of this is to be knowledgeable and confident in what you need. That is why it was important to highlight the difference between a fixed annuity, a variable annuity, and an indexed annuity. Now, you’re able to determine the right annuity for you, since not all of them are fit for individuals who are not afraid of high risks and losses.
Here, at Insurance Geek, we’re diligently working with over 30 carriers. We’ve made it our goal to help clients pin down the best insurance company. The great this is that you can do so by making use of our Annuity Rate Calculator that generates free quotes.
Take the next step together with us!