How do annuities work? Plain English Explanation of how annuities work.
Annuities are one of the most misunderstood financial vehicles available. Much of the confusion about these products comes from the fact that, although they’re often called investments, they aren’t really investment products in the traditional sense.
In most cases, you don’t measure the performance of an annuity the same way you would a stock, mutual fund or 401(k). Those vehicles are typically measured by the rate of return, meaning how much money you made on the investments above what you invested. The purpose of annuities, on the other hand, is to generate a stream of income; it’s more important to measure how much an annuity pays than how much it accumulates.
Annuities have similar qualities to bonds and CDs because of their relative safety, but there are also key differences. The main distinction is that most bonds and CDs are designed to provide temporary income before returning your original principal investment. Annuities, on the other hand, take your invested principal and turn all of it into an income stream, whether for a few years or for a lifetime.
What does annuity mean?
The word “annuity” is derived from the Latin root for year, which is also where English words like annual and anniversary come from. Historically, annuity was a a term used for something that provided annual income, such as annual allowances or legacy bequests.
There are other uses for annuities as well. For example, many prize payouts, such as lotteries, are annuity payouts. In fact, the publicized jackpot amount for many state lotteries is actually the sum of money a winner would receive if the jackpot was annualized over a set number of years instead of being taken as a one-time payment.
Another type of annuity is a structured settlement. This is when a person wins a court judgement and is paid through an annuity rather than in a lump sum, usually with certain tax advantages for the recipient and a savings for the payer.
Today, most people think of annuities as investment products offered by insurance companies for the purpose of saving for retirement. You make a single purchase payment or a series of payments to the company. The annuity can provide a lifetime stream of income or payments over a contractually defined term.
While annuity products come in different forms and offer a variety of features, the concept is fairly simple. Rather than thinking of it as “investing” your money with an insurance company, it may be more accurate to consider it a trade: In exchange for your premium deposit, the insurance company will provide you a stream of income.
The amount of income you receive will depend on a number of factors, including the annuity’s account value when you being receiving payouts. If you purchase an immediate annuity that pays income right away, the account value is the amount of premium you deposited. If you buy a deferred annuity where income won’t start for several years, the account value is your initial premium plus any interest it earns during the deferral period.
Your income stream will also depend on your age and gender if you choose lifetime income.
How does the insurance company make money from annuities?
Insurers charge annual fees that may total 2 percent to 3 percent or more of the annuity’s account value. These include a mortality and risk expense charge, and an administrative fee. If you purchase the annuity from an insurance agent, the company will have to pay him or her a commission based on how much you paid for the product. There will also be fees for any optional benefits.
With a fixed annuity, the insurance company will invest the premium you pay. The company seeks to earn an interest rate above what it credits to the annuity’s account value. For example, the company may determine it can earn 5 percent annually on its investment portfolio. So it may credit the annuity 3 percent annually and keep the remaining 2 percent to keep its business profitable and operating.
With fixed annuities, the company is guaranteeing a rate of interest, so its investments must be relatively stable and secure. If the company guarantees you a fixed rate of interest or a minimum guarantee, it is contractually obligated to pay it regardless of how its investments perform. The company is essentially taking on the risk of investment performance, unlike with stocks or mutual funds where your money is at risk.
To better ensure it can meet those guarantees, insurance companies invest mostly in high-quality bonds, such as highly rated corporate bonds and government bonds. Companies also have a fair amount of assets invested in mortgage loans, with smaller portions allocated to cash and other short-term investments, real estate and equities.
Much of what insurance companies invest in are interest-rate sensitive vehicles. Therefore, if the overall rate environment moves up or down, the rates credited to annuities will typically do the same. One of the criticisms of fixed annuities is that they earn very little during extended periods of low interest rates.
Insurance companies are regulated by state insurance departments. One of the responsibilities of regulators is to ensure to the best of their ability that companies can meet their obligations to policyholders. Therefore, they constantly monitor how companies are investing premium dollars and how much they have in reserve. In fact, each state requires that companies selling life insurance and annuities have enough liquid assets on hand to cover all current and future obligations, plus a little extra. That means when you purchase an annuity, the company has to hold back enough cash to make the required income payments down the road.
What about variable annuities?
One variation on annuities is the variable annuity. It works the same way as other annuities except for one major difference: Instead of the insurance company taking on the investment risk, you do. While this means the potential for a higher account value than with a fixed annuity, it also could result in your annuity losing principal value.
With a variable annuity, you direct the company to invest your premium in one or more subaccounts, which are mutual-fund like investments. Like mutual funds, these subaccounts offer different investment options in stocks, bonds, money market funds, and other securities. The number and variety of subaccount options will vary by company.
The money in those subaccounts will increase or decrease over time, depending on their performance. You can typically transfer funds between investment options.
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