How does an annuity work?

An annuity is essentially a contract between you and an insurance company, where you make a payment (either as a lump sum or through installments), and in exchange, the insurer promises to provide you with regular income in the future. While annuities can vary in structure, their basic operation can be broken down into two main phases: the accumulation phase and the distribution phase.

1. The Accumulation Phase

During this phase, you contribute money into the annuity. This can be done all at once (known as a lump sum payment) or gradually over time through a series of payments. Depending on the type of annuity you choose, the money in the annuity can either grow at a fixed interest rate (fixed annuity), be tied to the performance of investments (variable annuity), or earn returns based on a market index (indexed annuity).

Tax-Deferred Growth: One of the main benefits during the accumulation phase is that any interest or earnings on your annuity grows tax-deferred. You won’t pay taxes on this growth until you start receiving payments, allowing your money to compound over time.

2. The Distribution Phase

Once you reach the payout period, known as the distribution phase, the insurance company begins making regular payments to you. This is where you benefit from the annuity’s core purpose: providing a steady income stream.

Payout Options: You can typically choose how you want to receive your payments. Common options include:
Lifetime Income: You’ll receive payments for the rest of your life, regardless of how long you live. This is particularly attractive for retirees worried about outliving their savings.
Fixed Period: You can opt to receive payments for a specific number of years (e.g., 10, 20 years). If you pass away before the end of the term, your beneficiaries may continue receiving the remaining payments.
Joint Life: This option ensures that payments continue for the lifetime of both you and a spouse, offering long-term security for couples.

Types of Annuities and Their Functioning

How an annuity works depends largely on its type:
Fixed Annuity: You’re guaranteed a specific payout amount, typically based on a fixed interest rate. It’s a predictable and low-risk option.
Variable Annuity: Your payouts vary based on the performance of the investments you’ve chosen (e.g., mutual funds). While there’s potential for higher returns, there’s also more risk.
Indexed Annuity: The returns are linked to the performance of a specific market index, such as the S&P 500. It balances some potential for growth with protection from market downturns.

When and How You Receive Payments

You can generally decide when you want the distribution phase to begin. Annuities are often used as a retirement income vehicle, so many people choose to start receiving payments after they retire.

Immediate vs. Deferred Annuities:
Immediate Annuities: Payouts begin almost immediately (typically within a year) after making a lump-sum contribution. These are useful if you’re looking for an immediate income stream.
Deferred Annuities: Payouts start at a future date, often years down the road. During this time, the annuity grows tax-deferred, building up your retirement fund.

What Happens to the Money if You Pass Away?

Most annuities offer a death benefit, meaning if you pass away before the payout phase or during a fixed period, your beneficiaries may receive the remaining value or payments. The details depend on the annuity contract you’ve chosen, so it’s important to understand what happens in case of death when setting up your annuity.

Key Considerations
Fees: Annuities can have fees such as administrative costs, mortality and expense risk charges, and investment management fees. These can vary by annuity type.
Surrender Charges: Withdrawing your money early, before the agreed-upon payout period, may result in surrender charges. Make sure to know the terms if you might need access to your funds.

In Summary

An annuity works by allowing you to contribute money during your earning years, which grows tax-deferred. When you’re ready, the insurer will provide you with regular income payments, either for a set period or for life. This structure makes annuities an attractive tool for people seeking a reliable income stream, especially during retirement.