What is an annuity?

1 min readLast updated October 4, 2023by Rachel Carey

Concerned about making your retirement savings go further? An annuity could be an excellent option. This financial product can guarantee a set income for the rest of your life, no matter how long you live. Here’s everything you need to know about annuities.

What is an annuity? 

In the simplest terms, an annuity is a product that you can purchase from an insurance provider. If you’re unsure how to invest $100,000 and have a low tolerance for risk, an annuity could be a great option. 

Annuities are an excellent option for retirees as they guarantee you an income for life. Instead of worrying about your savings running out, you will pass over what’s known as the longevity risk to the insurance company. This means you can retire at 59 and a half and start claiming your annuity rather than worrying about your savings and continuing working longer than you’d like.  

How does an annuity work? 

An annuity turns your retirement savings or monthly premiums into a regular income stream. It’s a legal contract that ensures you’ll get a certain amount of money from the insurance company. Typically, you’ll receive regular monthly, quarterly, or annual payments to support your lifestyle in retirement. In some cases, you may also receive a one-off lump sum. 

Annuities are a great way to make your money go further in retirement. You purchase an annuity for an amount of money, generally a minimum of around $10,000 or the equivalent monthly contributions. Of course, the more expensive your annuity is, the higher the monthly payments or lump sum. 

There are two phases to your annuity: accumulation, where your money gains interest or grows through investments, and payment (also called annuitization), where your money is returned through a one-off payment or regular payments.  

How do I purchase an annuity? 

There are lots of ways to buy an annuity. If you’re confident about the kind of product you’d like, you can buy your annuity directly from an insurance company, bank, or mutual fund company. Not sure about the best option for you? A financial advisor can guide you toward a product that aligns with your risk appetite and retirement income goals.  

Be cautious about who you buy your annuity from. For example, if you’re looking at a fixed annuity and choose to purchase through an insurance broker, they must be registered in your state to sell insurance.  

Different types of annuities 

Broadly, there are three main types of annuities. Each has upsides, and there’s no objective best option, as each type of annuity caters to different risk appetites and desired income levels. Here’s a brief overview of the differences between the three: 

  • Fixed annuity: Fixed annuities pay a set amount every month or year for the rest of your life. You can invest in one all at once or choose a flexible premium annuity, which lets you make a series of payments. Each state’s insurance commission regulates fixed annuities. 

  • Indexed annuity: The amount you get from an indexed annuity will be determined by the stock market index it is linked to, like the S&P 500 Index. Essentially, they track the broad performance of financial markets. If the US economy is doing well, your annuity will increase. If it crashes, you may get less. State insurance commissioners also regulate indexed annuities. 

  • Variable annuity: A variable annuity is an excellent option if you’d like to have more control over how your annuity funds are invested. They’re regulated by the SEC, and most providers will let you choose from various investment options, typically mutual funds. Your annuity payments will be determined by how much you invest and how well these investments perform. 

You can also buy hybrid annuities, such as a fixed indexed annuity. These policies guarantee a minimum income based on the annuity you purchase but allow you to make your money go further with interest from a market index. 

Within the three categories, there are also immediate annuities and deferred annuities. Immediate annuities, as the name suggests, can begin paying out immediately. However, you’ll typically get less per month with an immediate annuity as the policy hasn’t had time to gain money through interest.  

The earlier you buy a deferred annuity, the more your premiums will enjoy tax-deferred interest growth. A deferred annuity is a great option to maximize your retirement income if you’ve maxed out your IRA or 401(k) pretty early in life.  

The pros and cons of annuities 

Fixed annuities guarantee your income without losing your money for as long as you live. The trade-off for security is that you will typically get a lower payout, which many people are happy to settle for in exchange for peace of mind. However, if inflation suddenly shoots up as it has over the last year, you may find that your set amount is no longer sufficient.  

As with any investment, there is an inherent level of risk with any variable or indexed annuity. Indexed annuities are considered moderate risk; there’s always a risk you could lose your money, but as they track some of the world’s largest and most stable companies and securities, it is lower than some investments.  

Variable annuities are best left to investors with a high-risk appetite as they are much more unpredictable than other products. You need to be comfortable with potentially losing the entire amount you invest in if you choose to go ahead with a variable annuity.  

What are the terms and fees for annuities? 

Each annuity product will have different fees, so check with your provider before purchasing. High fees can wipe out a good chunk of value from your annuity, leaving you with less money to enjoy, so choose your product wisely.  

Generally, you can expect to pay charges such as: 

  • Mortality and expense risk charge: Most annuities will come with these charges, typically around 1.25 percent of your account’s annual value. 

  • Additional fees: If you’re looking for something extra from your annuity, like a guaranteed minimum income, or need to transfer your account from one investment option to another, you may have to pay additional fees. 

  • Admin fees: Many insurance providers charge generic admin fees for things like record keeping—generally as a flat fee or a percentage of your account’s value.  

  • Penalties: You won’t be penalized if you wait until you’re 59 and a half to claim your annuity income. If you withdraw any money early, you may have to pay a ten percent tax penalty, plus any deferred taxes from the money you’ve contributed.  

If you’re considering buying an annuity or want some help with your retirement planning, Unbiased can help you find a financial advisor to meet your needs.

Senior Content Writer

Rachel Carey

Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.