1. Home
  2. Blog
  3. Retirement
  4. What Is An Annuity And How Does It Work?
How to Know When It’s Time to Retire - Quicken Loans Zing Blog

Retirement is a major concern for much of America and it’s understandable. We’re living longer than we ever have and it seems more certain than ever that Social Security may not be around when many of us retire. And even if it is, we’ll have to supplement it with other sources of income.

With this backdrop, saving for retirement has become more important than ever. According to a 2018 survey by PricewaterhouseCoopers, a global and multinational professional services network, 40% of employees surveyed stated that they are concerned about running out of money in retirement. In the sample, 33% are concerned about health issues in retirement, coupled with 28% who are worried about the rising cost of healthcare. Another 17% worry about not being able to meet basic expenses.

The good news is if you’re looking to save for retirement, you have several options including various flavors of 401(k) and IRA. One retirement option that can be a bit overlooked is an annuity, but it could give you a chance to get guaranteed income for as long as the rest of your life.

While annuities can sometimes be regarded with a wary eye, that’s because sometimes even the financial professionals find them confusing. However, if you’re in the right situation, having an annuity or two in your financial portfolio might make a lot of sense.

This article will go over the different types of annuities along with their pros and cons to help you determine whether an annuity would be a good option for you. Before we get there though, let’s define what we’re talking about.

What Is an Annuity?

At its most basic level, you can think of an annuity as an investment plan that can be used to provide you set income payments during retirement. The natural question is how annuities can guarantee a payment. The annuity is structured differently than most investments.

When you purchase an annuity, you’re actually signing a contract with an insurance company. This is unlike other options where you would have your investment managed through a financial institution (like 401(k)s or IRAs). Because it’s a contract, there are certain guarantees in terms of payouts you would receive, depending on the structure of the annuity.

An annuity can be funded in two ways: a lump sum payment to an insurance company or regular payments into it over time. For example, you might decide you want to pay into it once a month until you’re ready to start making withdrawals. The timeframe in which you’re making payments is referred to as the accumulation period. Once you start getting payouts, that’s the amortization period.

The difference between an annuity and taking that money and sticking it under your mattress is that the insurance company invests that payment or payments on your behalf.

Annuity contract investments are usually made in mutual funds. The selection of the particular fund depends on the type of annuity you buy. If you’re buying a lifetime annuity, they’ll be invested in things like bond market mutual funds that have a guaranteed return. If you choose other types of variable annuities, they may put your money in mutual funds with the potential for a higher return, but also the potential for no return and only getting your principal back. In that way, there’s at least a small advantage over a regular investment in that you don’t lose money (before considering inflation) and at least get your original investment back. There are other types of investments and we’ll get into those later.

Because these are mutual funds, the amount you earn on the investment you put in may be lower than if you were making individual choices in the market for stocks and bonds yourself.

However, the key thing to keep in mind here is that the stock market in particular is volatile. Although the average rate of return in stock investing is 7% per year (after inflation), that’s based on investing in a broad benchmark like an S&P 500 index fund. Also, you have to be investing over the long-term. There are years when the market could be up 15% and the next year it could be down 20%. Annuities at least make it possible to get your investment back at any given time without losing your shirt.

When you set up your annuity, you have the option to pay in and start getting payouts immediately or you can get them at some point in the future. If you choose to get the payment immediately, you pay in and then you get your first payment after the first interval when you would normally receive a payment. For example, if you elect to have monthly payments, you would get your first payment 30 days later. You can also choose quarterly or annual payments in which case the waiting period would be the first quarter or the first year.

For people not looking to take an immediate annuity, you have the option to pick the length of your accumulation and amortization periods. Funds contributed to your annuity during the accumulation timeframe are tax-deferred similarly to the way your 401(k) is handled.

In terms of receiving payments, there are three ways you can get them.

You can elect to receive a lump sum payment. At that point, it’s not really an annuity and financial advisers don’t often recommend this because of the tax implications, but it is an option.

The most common form of an annuity is probably the one that guarantees you payment for the rest of your life. Finally, you can get an annuity that also pays your beneficiaries for a certain period of time. These can also be joint annuities that will continue to pay a spouse in the event of the death of the significant other.

Company-funded pensions are mostly going the way of the dodo, but you can think of an annuity as a self-funded pension that gives you some amount of money for the rest of your life.

Because the income continues for life, you can’t outlive your money. You’re guaranteed some sort of income until your death, assuming you keep your annuity.

Types of Annuities

When categorizing annuities, they really break down into three basic categories.

Fixed annuities guarantee a payout that doesn’t change for as long as you have the annuity. This is a good way to know exactly how much you’ll be receiving on a monthly, quarterly or yearly basis. These are highly regulated by state insurance commissioners and will pay you a fixed amount of interest.

Variable annuities offer the potential for higher payouts, but they also come with higher risk including the potential not to make any return on the investment at all. The performance of your annuity is tied to underlying mutual funds, and when the funds do well, you have the ability to gain a higher rate of return, but if the performance of the investments underlying the funds tanks, your rate of return could be zilch. In no event can you lose your initial investment, though. These annuities are regulated by the Securities and Exchange Commission (SEC).

A middle ground between the two is an indexed annuity. An indexed annuity guarantees a certain rate of return, and any return above that is tied to the performance of an index like the S&P 500. If the index performs well, you could make extra money with your next payout. If it doesn’t, you still get the amount you’re guaranteed. The downside of these annuities is that there’s a cap on the amount of gains you can make. For example, you may be able to only make up to 85% of the gains of the S&P 500. In addition, because it’s tied to an index fund, if the market loses money, only a certain percentage of your income is protected. Commonly, this works out to be 87.5% of the principal. This means that the market has a particularly bad year, you could end up losing money. You have the chance to make more money, but there’s also more risk involved.

How Annuities Work

In addition to the different types of annuities available, there are a variety of options in terms of how the annuities are set up. You can choose when payouts begin, how you choose to fund the annuity and how long the annuity will last.

When it comes to choosing the timing of the payout, there are a couple of different options.

  • Immediate annuities: These annuities begin payouts shortly after the annuity gets its first funds. Depending on the frequency with which you elect to receive payments, payments could begin within the next month, quarter or after a year if you select annual payments. This may be good for older annuitants – a term for those taking out an annuity – who are looking for a steady income stream throughout retirement.
  • Deferred annuities: Deferred annuities allow for you to pay into the annuity and not start withdrawals until some later date in the future. The advantage of this is that your investment is allowed to sit and grow over time based on the performance of whatever funds are selected by the insurance company.

In addition to choosing the timing of the payouts, you also have a couple of funding options.

  • Single-premium annuities: With this type of annuity, it’s funded with one lump sum payment. This might be used if you wanted to move a chunk of your money into the annuity all at once.
  • Multiple-premium annuities: These annuities allow you to pay in over time to grow the funds within the annuity. This would be useful if you’re using your annuity to set aside a certain amount of money each month, quarter, year, etc.

You can also choose the length of the amortization period – how long you receive payments.

  • Lifetime annuities: In a lifetime annuity, the annuitant receives a certain amount of income for the rest of their life either in monthly, quarterly or yearly installments. This is one potential option for people concerned about the possibility of outliving their money. Because the payment lasts for as long as you live, it may get smaller over time.
  • Fixed-period annuities: With this type of annuity, its payouts last for a certain term, say 10 years. This results in higher payouts, but there’s the chance that you’ll outlive the term of the annuity.

The Pros and Cons of Annuities

Annuities have both benefits and drawbacks. Let’s run through these now to help you make an informed decision.


The main selling point for an annuity is that you can give yourself a guaranteed income stream of at least the principle of your annuity in retirement. This can be paid to you on a monthly, quarterly or annual basis.

Depending on the way your annuity contract is set up, you may be able to specify a beneficiary for the annuity in the event that you pass before your funds run out. They can either be paid the balance of your funds or a guaranteed minimum amount.

Unlike a 401(k) or IRA, where you’re limited to contributing a certain amount per year based on IRS tax rules, an annuity allows for unlimited contributions.

Finally, depending on the type of annuity you select, most or all of your principal is protected to greatly limit or eliminate the ability to lose money on your annuity investment.


No investment strategy is without its problems, and annuities have a few of them.

For starters, fees of up to 3% or more per year can cut into your return. Some of these fees include:

  • Surrender charges: These charges apply if you’re withdrawing your funds before the time stipulated in your contract. If you’re buying a deferred annuity, these charges might typically apply for 6 to 8 years after you take it out.
  • Commissions: There may be either flat commissions or ones tied to the performance of the investment. It’s important to know what these are because they’ll reduce your rate of return.
  • Insurance charges: Often referred to as a mortality and expense risk charge, this compensates the company issuing the annuity for the insurance risk assumed under the annuity contract.
  • Investment management fees: You’ll typically pay a fee for the management of the investment of the annuity. This is typically compensation for the people who decide which funds to invest your annuity in. These charges can be higher for variable and indexed annuities than they would be for fixed-period annuities that are just invested in things like bonds.
  • Rider charges: These are fees for special features like guaranteed minimum returns and the ability to add a beneficiary.

In addition to the surrender charge, the IRS penalizes those who start withdrawing from annuities if you do so before 59 ½ years of age. There is a 10% tax penalty on top of income taxes owed. This can make it difficult to access your money if you needed to get it out early.

In addition to the fees and penalty for early withdrawal, annuities are taxed differently based on whether it’s a qualified or non-qualified annuity. It’s important to know what kind of annuity you buy, so let’s briefly define these.

Qualified annuities are typically offered as part of employee retirement funds and can be bought with money contributed from a tax-deferred 401(k) for example. You would owe the taxes only when you start making withdrawals. Income is reported for the tax year when you receive it.

Non-qualified annuities are purchased with money you’ve already paid taxes on. Therefore, you only pay taxes on the earnings of the annuity and not the principal itself when you start withdrawing funds. Determining what portion of your withdrawal comes from principal and what comes from the interest is based on something called the exclusion ratio which takes into account the funds used to purchase the annuity and the amount of time that annuity has been in effect along with the interest earned. One downside of a non-qualified annuity is that if you outlive your life expectancy based on actuarial calculations – basically mathematical risk analysis – withdrawals after that point are fully taxable. This taxation scheme is different from some other investments where only the capital gains would be taxed.

You can find more on annuity taxation, but if you’re unsure of anything, we certainly recommend speaking with a tax professional.

The combination of the fact that the funds are stuck for a period of time, as well as fees and taxes cutting into the return can make people wary of getting an annuity as part of their retirement planning. They certainly aren’t for everyone.

When an Annuity Might Be a Good Idea

Now that we’ve gone over the pros and cons of annuities, when is an annuity something actually worth considering? Here are some guidelines:

  • Your age: If you’re about to enter retirement, an annuity might be a better choice than when you’re younger. When you’re young, your investment strategy might change and you’ll be locked into the annuity until your at least 59 ½. When entering retirement, you’ll have a better idea of your finance strategy and won’t have to wait as long to withdraw.
  • Fixed expenses: Having an annuity can help cover the expenses that you know are going to come up every month.
  • Invest extra funds: If you’ve already invested all you legally can in a qualifying 401(k) or IRA, you can put the extra funds into an annuity because there’s no limit on contributions.

Annuities aren’t for everyone and there are many retirement strategies that might be worth taking a look at such as a 401(k) or IRA.

If you’re looking for a passive income stream with money coming in every month, another option would be to invest in real estate that you can rent out to provide extra income in retirement.

We recommend you speak with a financial advisor before settling on a retirement strategy that works best for you.

This Post Has 2 Comments

  1. Can my union deny me for a hardship withdrawl for the cares act? Ive been in the union for 20 years now. Just want to know my rights. I want to pay it back also. Thank you

    1. Hi Dominic:

      Hopefully they don’t, but the short answer is that they may be able to. The government has offered relief that removes many of the potential tax snags that are associated with an early withdrawal or a loan, but the employer is not required to offer specific hardship withdrawals related to the coronavirus. I’m going to suggest a couple of resources. One is from the Consumer Financial Protection Bureau and the other is from the Department of Labor. The second one is a little bit longer and not all about retirement benefits, but since you mentioned wanting to pay it back, I thought it would be helpful to have a resource that at least contemplates loans as well as hardship withdrawals. It sounds like you want to do a loan.

      The tax portion of this is going to come down to what type of retirement plan you have, so definitely check out that first resource and see if you have a plan that would qualify for the tax relief. Secondly, for tax purposes, in order to qualify, you have to have suffered a hardship related to the virus. The guidelines for that are also laid out in the first to link. As to whether your union is going to go along with any of this, the only way to find that out would be to speak with your plan administrator, but I hope this at least gives you some more information.

Leave a Reply

Your email address will not be published. Required fields are marked *