Personal Finance 101: How Does an Annuity Work?

Understanding Annuities and Deciding If One Is Right for You

pf101Sometimes, it’s really no surprise to me that so many people are uncomfortable when it comes to managing their finances. There are so many financial products out there, each with their own benefits and drawbacks and pitfalls, that it can be overwhelming even for me, someone who spends a lot of time following all of this stuff.

This brings us to annuities, which is yet another option that people have for retirement. Connie writes in with a question about them:

What exactly is an annuity? My mother and father in law are apparently retired and living mostly off of the proceeds of an annuity, but I don’t really understand how it works. They mentioned it the other day and I felt kind of dumb just nodding my head.

An annuity (in the United States) is an arrangement between two parties. One of them, usually an individual like yourself, pays some lump sum to a second party, usually an insurance company. After that, the insurance company gives regular payments to the individual for some period of time specified in the arrangement.

There are two general kinds of annuities:

Annuity with period certain

The first kind is an annuity that specifies a certain period for the payments.

An example: you might give $100,000 to an insurance company for a 20 year annuity that starts on January 1, 2011 and ends on December 31, 2030. The agreement requires monthly payments from that annuity and guarantees 3% growth over the period of the annuity. That company would then issue you a payment each month for $554.60. At the end of the arrangement, you both just walk away from it.

Life annuity

The second kind is the life annuity and it tends to be the more common one when it comes to retirement savings. Usually, how this works is that you agree to pay some lump sum to a company and they promise to pay you a certain rate of return on that money each year for the rest of your life.

I’ll use the Smart Consumer Gift Annuity sold by Consumers Union (the publishers of Consumer Reports) as an example of such an annuity since it’s known by a lot of people. On their advertisement, they offer a little table that tells you the yearly rate of return you’ll get for the rest of your life at various ages.

At age 60, you’ll get a 5.2% return for the rest of your life. So, if you pay $100,000, they’ll pay you $5,200 a year for the rest of your life. At age 70, you’ll get a 5.8% return. At age 80, you’ll get a 7.2% return, and at age 90, you’ll get a 9.5% return.

Some life annuities offer extra tax benefits if they’re done in conjunction with a nonprofit organization, as with the above example (often, the initial payments are considered charitable contributions and are tax deductible). Many large charities and nonprofits run such programs.

So, let’s say you’re 60 years old and you’ve accumulated $1 million in lifetime savings. You’re a big believer in a certain charity and you want to help support them while also helping yourself in retirement. So, you sign up for a life annuity with them that pays a 5% rate of return. For the rest of your life, you get a $50,000 annual payment from them.

Are annuities a good investment?

Such investments are a solid idea on paper, but they have one major risk: what happens if the organization you bought the annuity from goes under? Most likely, you’re out of luck. To put it simply, I would never buy an annuity without the backing of some very reputable organizations, especially if I were putting a great deal of my savings into that annuity.

They can also be a pretty big loser if you pass away early. If you buy a lifetime annuity for $1 million at age 60 and die at age 66, you’ve only received $300,000 back from that initial investment – the rest is gone and can’t be passed down to your children. Other investments retain their value for inheritance purposes.

Would I buy an annuity?

I would buy an annuity as part of my overall retirement strategy. I would preferably buy one associated with a charitable group I believed in, both for the tax advantages and for the support to that organization. I would not buy one as my entire retirement strategy, as that would expose me to more risk (the risk of the future of that organization that I purchased the annuity from) than I would like.

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  1. cv says:

    I spent a few months as a temp in the annuity department of a brokerage firm, and one big thing to watch out for that you missed is the fees involved. Our financial consultants loved annuities (the big insurance company kind, not the nonprofit kind) for the commissions they got on them. Annuities can be a good part of a retirement strategy, since as an insurance product they can reduce worries about running out of money if you live a long time past retirement age, but take a look at the fine print and make sure you’re getting a good deal.

  2. cv says:

    Also, some annuities have a life insurance component in the form of a “death benefit”, which is an amount that will be paid out to your chosen beneficiaries upon your death.

    Some companies also offer variable annuities, where the payout amount varies with interest rates or how the stock market is doing. These can be decent investments, but they can also have crummy terms while sounding almost too good to be true. Do your research before committing, and make sure you can handle variable payouts.

  3. jim says:

    “what happens if the organization you bought the annuity from goes under? Most likely, you’re out of luck”

    All 50 states, Puerto Rico & D.C. have state guarantee associations that back and guarantee insurance companies. Minimum guarantee for annuities is $100k and many states provide higher limits on the guarantees. So the annuity is safe in case of insurance company failure up to certain limits. Much like FDIC guarantees. You can guarantee all your money buy buying multiple annuities at the guarantee limit from multiple insurance companies.

  4. L says:

    When I think of annuities, I always think of the quotation from Jane Austen’s Persuasion from the grumpy Fanny, trying to be as cheap as possible to her impoverished in-laws and trying to give them as little as possible, “People always live forever when there is an annuity to be paid to them…”

  5. L says:

    Argh, I mean Sense and Sensibility, not Persuasion. Jane would not be amused.

  6. Chris Gagner @ SmartPF says:

    Annuities aren’t a terrible idea, but I don’t like the low rates of return that are usually associated with them. When I’m saving for retirement, I tend to lean more towards using different types of mutual funds.

    Even since the recession, I still believe in stocks and still invest in good growth stock mutual funds. Right now, they’re at great discount. After all, isn’t the point of investing in stocks to buy low and sell high?

    Nice, informative post, but I don’t personally recommend or use mutual funds.

  7. George says:

    There’s one other trade-off with an annuity: there’s no way to tap the capital that’s supplying the income stream should the need arise.

    Maybe you have a legal bill or medical expense and need the money NOW… well, it won’t be there.

  8. Dee says:

    Can someone explain the math behind the $554.60 monthly payment in the 20 year annuity example?

  9. George says:

    @Dee – you receive 240 payments of 554.60 at 0.25% per payment (=3% per year). Think of it like a mortgage in reverse… the payments consist of interest and principal. You can figure out the amortization in reverse if you use a mortgage calculator with 20 year mortgage, 3% APR.

  10. AnnJo says:

    Another big risk to annuities is inflation. The purchasing power of your guaranteed monthly payments will decline in the event of inflation, often dramatically. (If you’d bought an annuity paying $1000 a month in 1970, those monthly payments would only buy the equivalent of $295 in 1990, for example, and $172 last year.)

    Maybe I’m missing something, but basically, as long as inflation is operative, it seems to me that you will receive your guaranteed monthly payments, but they will buy less and less. If deflation should take hold, then your guaranteed payments would stop (the company rationally choosing default) and you would be left to recover your pro-rated initial payment from your state’s guarantee fund, with no meaningful option for reinvestment to generate the stream of income you were counting on.

    I can see a need for these instruments given the few options people often as they approach old age (impaired cognition, inept or dishonest family members and financial advisors) but I can’t ever see them being “good investments.”

  11. It’s amazing to me that so many big lottery winners opt for the cash payout rather than the annuity over time. The govt. takes a majority of their money. That’s possibly why they had to win the lottery as they may not be the smartest when it comes to money and fv of money.

  12. Dee says:

    @ George: Thank you for explaining that.

  13. Brian says:

    AnnJo brings up a good point. There are annuities out there with an inflation rider attached, where your payments will increase annually based on inflation. Its a smart option.

    Also, as far as the interest rates Trent quotes on the Lifetime annuities – its very misleading. You will get a higher payment at higher ages, but its simply because you have a lower life expectancy, not that you are getting better interest return. Just shows that the advertising out there is always suspect, especially in the financial services industry.

  14. Nick says:

    How can you write an article about something you have no idea about? Missing the facts behind the state insurance guarantee is a big miss. Other then that all you told me is how little you know about annuitys.

  15. Craig Callender says:

    @Dwight Anthony: Taking the cash payout isn’t a horrible idea if you plan on investing it (in a business, stocks, etc…) and not just spending it. If there’s a $230,000,000 payout the cash payout might be in the range of about $100,000,000. Even after the government takes it’s half, you’re still left with $50,000,000 to invest in something that makes you happy. I’d take the $50,000,000 and start my own business.

    If you’re starting a business with a low cost of entrance it would make more sense to take the annuity as you’d be making some high salary each year from the annuity to pay your bills and wouldn’t need a lot of money to start your business. However, if you want to start the next McDonalds, you’re going to need lots of capital to build all your stores, franchise, marketing, etc….

  16. I sell some types of annuities at my job. (I’m a personal banker).

    You also did not mention that you do not always have to annuitize (take the monthly payments). Many people use annuities as vehicles to let their money grow tax deferred until they decide they need to use it. Some products let you take a percentage of your principal each year without penalty if you choose, but you do not necessarily need to get locked into the monthly payments, which you cannot change once you start them. Like IRA’s, you do not want to take withdrawals from an annuity until you are 59 1/2 in order to avoid IRS penalties.

    There are about a million variations of annuities; fixed, index, variable…most folks have no idea of the range of options they have. For folks in the right situation, annuities can pay way, way better than other options like CDs, and there are all kinds of levels of risk tolerance–completely conservative to some that risk a little bit to get a higher return.

    As with any investment, make sure you understand what you are getting into. Have a good relationship with your advisor. Get your questions answered before you sign on the line.

    Insurance companies are coming up with many kinds of innovative products right now. If you are griping about low CD rates and don’t need access to your money right away, you should learn about annuities. Researching all of your options lets you make a more informed choice about your money. If your banker or investment advisor makes a recommendation, hear them out!

  17. MattJ says:

    #11 Dwight:

    With big lottery winners, the goverment takes the majority of the money in either case. There’s essentially no difference in the taxes owed, except inasmuch as tax rates change over the 20 year payout of a typical lottery annuity.

    Edward Ugel wrote a book “Money for Nothing” about working in the annuity-to-lump-sum business as a lump sum salesman. Essentially, folks who won the lottery ‘back in the day’ had no choice but to take the annuity, because the lump sum option weren’t offered until . Not being, as you say, the smartest when it comes to money, these winners would (and still do!) quickly find out how easy it is to spend your $5 million / year annuity payout and more. In short, they would have 15 years of lottery payouts coming, and still be flat broke, waiting on that next check.

    Enter the lump sum industry and guys like Ugel, who would offer to buy a portion (or all) of the remainder of the annuity for a lump sum, often at horrible rates of return. His business, as he describes it, is a nasty one, and the only ways to avoid guys like him if you win the lottery is to hide (his job was to find you, though, and he was good at it) or, once the option became available, to take the lump sum.

    Ugel claims (and based on his book, I agree) that the lump sum payout is the better deal. The website “The Straight Dope” has a page on which is the right choice, though he doesn’t touch on the possibility of being hounded by the lump sum industry, he’s concerned about the annuity interest rate, tax treatment, and whether your heirs get the annuity in the event of your death (varies by state, apparently)

  18. Evita says:

    Trent picked an interesting subject but the post is so obviously lacking in research as to be nearly useless. Too bad!

  19. Johanna says:

    @Evita: Trent’s passion is for writing, not research. Or something like that. :)

  20. Hey! I could have sworn I’ve been to this website before but after checking through some of
    the post I realized it’s new to me. Anyhow, I’m definitely happy I found it and
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