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.

Trent Hamm
Trent Hamm
Founder of The Simple Dollar

Trent Hamm founded The Simple Dollar in 2006 after developing innovative financial strategies to get out of debt. Since then, he’s written three books (published by Simon & Schuster and Financial Times Press), contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.

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