How Annuities Work

Annuities are contracts with an insurance company, but they are not typical insurance policies, such as renters insurance. With annuities, you give the insurance company money now, and the company returns your investment with interest later. In its simplest form, you put money in, it grows, and you get your money back. To best grasp how annuities work, it helps to understand their three phases:

Purchase period. You pay money in to the issuer over a defined period of time. The amount of time you pay in can vary anywhere from a onetime payment to many smaller payments spread over a time. Single payment annuities are usually made, for example, when someone receives a legal settlement, wins the lottery, sells a business, or receives a large inheritance). The amount paid will vary largely on the annuity size and when the payments will commence. For example, if you begin making Purchase Payments at 28 years of age and plan for those funds to accumulate so that you can receive income at retirement, then you will have many Purchase Payments in smaller denominations. Conversely, if you enter into the same sized annuity contract when you are 58, and want income beginning at age 65, you would have to make fewer Purchase Payments in greater amounts.
Accumulation or growth period. This is the time period in which your money enjoys compounded growth. The accumulation period can overlap with the purchase period. The money you put into an annuity begins accumulating at the time it is contributed. The more money you put into your annuity contract and the longer you let it “sit” in the accumulation period, the more you will receive back in income during your retirement years.
Distribution phase. This is also called the annuitization period. At a certain date, the insurance company will send you regular payments. Those payments can be for a time certain, for example, ten years. Another alternative is to receive payments starting at a certain date and lasting your lifetime. Under this scenario, your payments cease when you die. Some annuities, called joint and survivor annuities, continue to pay your spouse upon your death. With a joint and survivor annuity, payments continue until the widowed spouse dies. The terms can vary by the issuer and contract type. The insurer determines how much to pay you based on an actuarial calculation. The insurer considers how much you paid into the contract, how long it anticipates you will live, and how much it costs to service your contract. If you live longer than the actuarial tables predict, then you will receive in income more than you paid for the annuity. Conversely if you die earlier, you will receive less than what you paid for the annuity. For example, if you pay in $75,000 for a lifetime annuity, the insurance company agrees to pay you for life, however long that is. In taking that risk, the insurance company first calculates how long they think you are going to live based on factors such as age and gender. For example, if the insurer determines you will likely live for 20 years, it will calculate how much to pay you each month for those 20 years. If you live another 40 years, it does not matter. The insurance company is obligated to continue to pay you the agreed upon payments each month until you die.

Annuities appeal to conservative investors because they provide a steady stream of income. Unlike stocks, bonds, mutual funds and other common investment options, annuities are guaranteed.

Insurance companies issue annuities because they are the flip side of the bet they make on issuing life insurance. When issuing life insurance, the insurance company is betting on the fact that you will live, and pay your annual life insurance premiums, for a very long time. The insurance company is betting that the sum total of the life insurance premiums you pay will exceed the amount of death benefit they have to pay to your beneficiaries.

To counteract the longevity risk - or the risk that you will live a long, long time, they issue annuities. With an annuity, the insurance company predicts you will die sooner rather than later. The shorter your life, the less monthly income payments they have to give you. Ultimately, the insurance company is betting on the fact that the individuals in its annuity pool of business will receive payouts in a much smaller denomination than the collective face values of their policies. But, there are other ways insurance companies make money on annuities. The insurance companies profit on fees and investment growth in excess of the pay out. For example, in addition to fees, insurance companies may promise to pay 5% on fixed annuities, yet their general investment account might yield much higher returns.

Not all annuities are alike. In fact, they come in all shapes and sizes, geared towards addressing a wide array of needs. There are two main types, fixed or variable. Fixed annuities offer guaranteed income. Variable annuities involve more risk than fixed annuities, but offer the potential for higher return. The amount of income you receive from a variable annuity fluctuates with each payment depending upon the investment portfolios you choose.