Annuities 101: Guaranteed Retirement Income Basics

Retirement planning can be overwhelming. And the challenge isn’t just figuring out how you'll pay your bills once you stop working. It's also navigating the seemingly endless list of planning options and financial instruments that you can choose from.

One popular financial product for retirement is the annuity. At first glance, annuities can appear complex and overwhelming, but they’re actually pretty straightforward.

What Are Annuities?

Technically, an annuity is any series of payments made at regular intervals. But if you're reading about annuities online, you’re probably reading about retirement annuities.

Retirement annuities are insurance products that provide guaranteed retirement income. They're a contract between you and your insurer. The agreement is that you give your insurer money now in the form of a premium, and then they pay you a steady stream of income in retirement.

What Aren't Annuities?

Annuities are not pensions. Annuities have some similarities to pensions (they both provide you with regular retirement income), but they're not the same. The big difference is that pensions are usually provided by an employer. On the other hand, annuities and life insurance retirement plans are different from life insurance but they are a product you can purchase yourself from a life insurance company.

Annuities are not 401(k)s or IRAs. Annuities can help you fund your retirement, but there are many differences between annuities and 401(k)s, which are employer-sponsored retirement savings plans. And they're not the same as individual retirement accounts (IRA) either, although you can hold an annuity inside of an IRA.

Annuities are not certificates of deposit (CDs). While both are very low-risk ways to grow your money over a term, CDs are designed to be short-term investments. They have relatively low interest rates, and they don't pay you a retirement income. In contrast, annuities are designed to be long-term investments. They typically have much higher crediting rates, and they provide guaranteed retirement income.

Annuitant vs. Annuity Owner

A quick note on common annuity terms: annuity owner vs. annuitant. The annuity owner is the person who applies for the annuity and pays the premium. The annuitant is the person who receives the annuity payments. The annuity owner is usually also the annuitant, but not always.

How Do Annuities Work?

In general, annuities have two phases: the accumulation phase and the payout phase. In the accumulation period, you fund your annuity with premiums. This is like adding money to your account. You can choose to fund your annuity in a single lump-sum payment, or over time in periodic premium payments.

To start the payout phase, you annuitize your annuity, which means you convert it to a stream of income payments. With annuitization, you can usually choose the timing and frequency of the payments.

Difference in the Types of Annuities

While annuities generally work the same way, there are several different types of annuities available. Insurance companies offer a variety of annuity products to suit consumers with different financial circumstances and needs.

Here are some of the main types of annuities.

Single Premium vs. Flexible Premium

In a single premium annuity, you fund the annuity in a single lump sum. With a flexible premium annuity, you fund the annuity with periodic payments over a period of time—often many years.

Immediate vs. Deferred Annuities

With immediate annuities, you skip the accumulation phase. These annuities start to pay you back very soon after you buy them. They’re best for people already in retirement or very close to it.

Deferred annuities pay you back after your money has had time to grow with interest. They’re ideal for people who want to maximize earnings.

To get the best of both worlds, some people pursue a split annuity strategy, where they purchase both an immediate annuity that starts paying them back now and a deferred annuity that grows and pays them back later.

Fixed, Fixed Indexed, and Variable Annuities

Annuities differ in how they calculate their interest rate or rate of return.

Fixed annuities have a fixed minimum interest rate. They guarantee you’ll earn that fixed rate—or more—over the term (as long as you don’t make any early withdrawals). These are the safest annuities. All Canvas Annuity's products are fixed annuities.

Variable annuities bring in stock market risk and volatility. When you buy them, you choose sub-accounts to put your money into. These sub-accounts are tied to investments like stocks. Depending on how the investments perform, your crediting rate may increase or decrease. You could even lose money, so they are much riskier than fixed annuities.

Fixed indexed annuities are a mix between the two. When you buy a fixed indexed annuity, you link your funds to a market index, like the S&P 500. There is also a fixed minimum interest rate—usually 0%—that guarantees you won’t lose money due to market performance. Depending on how the market index performs, your interest rate may increase or decrease, but it will never fall below the fixed minimum rate.

Qualified vs. Non-Qualified Annuities

Annuities can differ based on how they’re taxed.

Qualified annuities are funded using pre-tax dollars. They grow tax-deferred, but you’ll have to pay ordinary income taxes when you receive money from your annuity. You will also have to take required minimum distributions from this type of annuity.

Non-qualified annuities are funded with money you’ve already paid taxes on. You don’t have to pay taxes on that money again, but you do have to pay ordinary income taxes on earnings.

Single vs. Joint Annuities

Annuities also differ depending on how many annuitants they include.

A single life annuity guarantees payments to one annuitant for the rest of their life.

A joint life annuity guarantees payments for the lifetimes of two people—usually a person and their spouse. Since guaranteeing payouts for the lifetimes of two people is riskier for the insurance company, joint annuities usually have lower payouts.

Lifetime Income vs. Term Annuities

Lifetime income annuities provide you with income payments for the rest of your life. In contrast, term annuities provide income for a given term (say, 10 years)—and no more. Most insurance companies offer lifetime annuities or the option to make your annuity a lifetime annuity. At Canvas Annuity, all of our annuities provide lifetime income at no additional charge.

Customizing Annuities with Riders

You can often customize annuities with optional add-ons called “riders.” Each insurance company offers its own set of riders for its specific annuity products. Here are some of the most common riders that you'll see.

Enhanced Lifetime Income Benefit

Some companies offer riders to enhance the lifetime income benefit in some way. For example, they may offer a guaranteed lifetime withdrawal benefit on the more risky fixed indexed and variable annuities. This guarantees that you’ll receive retirement checks until death—even if the annuity runs out of money.

Death Benefit Rider

Death benefits allow you to designate a beneficiary to receive the remainder of your annuity should you die before receiving all your payouts. You can usually choose to add on a death benefit rider if it is not already included in the annuity contract.

Cost of Living Rider (COLA)

When you annuitize your annuity, you usually receive a specified monthly income that is fixed for the entire term. Normally, that income does not account for inflation.

A cost of living rider increases your income payments based on an inflation measure—often the “consumer price index.” This helps you hedge against inflation.

Annuity Taxes, Fees, and Charges

There are a number of different fees, charges, and costs that can be associated with annuities. Here are the most common ones, explained.

How Much Do Annuities Cost?

You purchase an annuity by paying a “premium.” This isn’t really a cost; it’s more like depositing your money into a bank account. The money is yours both before and after you open the account. However, it's not as accessible as it would be in a bank account.

Typically, you can fund your annuity with as much money as you like, but most companies have a minimum value for funding an annuity. At Canvas, the minimum for our Flex Fund product is $5,000, and the minimum for our Future Fund product is $2,500.

Annuity Taxation

Annuities grow tax-deferred. That means that you don’t pay taxes on the earnings while they’re growing. Note that annuities are not "tax-free." You will have to pay taxes on your annuity payments when you receive them. Annuity payments are taxed as ordinary income in the year you receive the payments.

Early Withdrawal Fees

Most deferred annuities allow you to take money out of your annuity early if you need to. But there can be fees for doing this.

Most insurance companies charge a fee called a “surrender charge” if you take money out before the surrender charge period (sometimes called the "surrender period") ends. The surrender charge period is stated in your contract.

The IRS also may charge a tax penalty if you withdraw money from your annuity before you turn 59½. See our article on withdrawing money from an annuity for more details on early withdrawal rules and fees.

Finally, withdrawing from an annuity is very different from the practice of selling annuity payments for cash.

Annuity Commissions

Most annuity companies pay their sales staff commissions for selling annuities. This isn't a cost you’ll see added to your contract, but it does lower the interest rate the insurance company can credit you. The more expenses the insurance company incurs to sell the annuity, the lower the crediting rate they can give.

At Canvas, we don’t pay our licensed representatives a commission. That ensures that they provide great service and have no incentive to pressure you into a product that isn’t a good fit. It also means we can offer some of the best interest rates in the industry.

Annuity Pros and Cons

Annuities are powerful retirement planning products, but they’re not for everyone. Here are some of the benefits and drawbacks of annuities.

Annuity Advantages

Among the massive benefits to retirees are the following advantages:

Guaranteed retirement income. Annuities alleviate the stress of wondering how you'll pay your bills in retirement. Their steady income gives you some certainty about the future and allows you to plan your finances with confidence.

Tax-deferral. Tax-deferred growth means your annuity grows faster. It also means that you pay taxes later, in retirement. Since most people fall into lower tax brackets in retirement, they often pay fewer taxes overall.

Stable rates of return. Fixed annuities are very safe financial products because they guarantee growth over the annuity contract term (provided you don't make early withdrawals). The rates aren't sky-high, but they're solid—and better than other low-risk investment options like CDs.

No contribution limits. Your IRA has a contribution limit, but annuities usually don't. That means you can put away as much money as you’d like to secure your financial future.

Annuity Disadvantages

There are some disadvantages to annuities, too.

These include:

Illiquidity. Illiquidity means that your money isn't very accessible. After you purchase an immediate annuity, you typically can't retrieve your money until you receive your annuity payments (except for during the free look period). With deferred annuities, you typically can withdraw your money early, although there may be rules and fees that apply.

Fees. Some annuity companies charge substantial fees. At Canvas, we offer zero account charges, or fees on our annuities. Before you purchase your annuity, be sure you’re aware of all the fees.

Not backed by the FDIC. The Federal Deposit Insurance Corporation (FDIC) insures up to $250,000 that you put in FDIC-insured bank accounts. But the FDIC doesn’t cover annuity contracts. Instead, annuities are guaranteed by the financial strength of the issuer.

Who Is an Annuity Right For?

Annuities are ideal for anyone who wants to add security to their retirement plan. They offer guaranteed retirement income to supplement pension income or a social security check. They help alleviate anxiety for those who aren't sure how they’ll pay their bills once they stop working. Even if you’re not close to retirement, you can buy one now and watch it accumulate money over time.

Annuities are great for:

• Retirees. People already in retirement can use annuities to turn their savings into predictable income.
• People at the end of their careers. Annuities are a great option for those approaching retirement who want to get their financial ducks in a row.
• People with retirement savings. Annuities are a fantastic option for anyone looking to convert their 401(k) or IRA into a steady paycheck.
• Young people. Annuities help young people get a head start on their retirement plan and steadily grow their money over time.
• Long-term investors. Annuities can benefit anyone who wants a long-term, low-risk way to earn steady growth on a chunk of cash.

But annuities aren't right for everyone. They're not ideal for:

• The super-rich. If you have so much cash that you're confident you can support your lifestyle through retirement, you may not need an annuity. (Although, a fixed annuity can still be a good addition to a diversified investment strategy.)
• People that need liquidity. While you often can access your money in a deferred annuity, it may not be easy or cheap. If you might need to access your money in the near future, an annuity may not be the best place to put it.
• Short-term investing. Annuities are designed to be long-term investment products. They're not ideal if you’re looking to grow your money over the short term.

An Annuity Can Stabilize Your Finances in Retirement

While annuities can look ominous and complicated, they're actually quite simple: They offer you the ability to trade some money now for a guaranteed income later. Annuities help alleviate the stress of uncertain income during retirement. They grow your money and ensure that it’s working for you. If you're trying to develop a financial plan, talk to a financial advisor about annuities.

They might be a worthwhile addition to your portfolio. Looking for more information on how annuities work? Feel free to get in touch with our licensed representatives. They're very knowledgeable and are happy to help you understand the role annuities can play in setting yourself up for a stress-free retirement.