What is an annuity?

What is an annuity?

An annuity is a financial product that’s designed to provide payments over time, often used to help support someone in retirement. The annuity definition is fairly simple: You contribute money, either in a lump sum or in smaller payments, and in return, the annuity may pay you back on a schedule — sometimes for a set number of years, or even for the rest of your life.

There are two general types of annuities: deferred annuities and payout annuities. This article focuses on deferred annuities, since they are much more common and often serve to help build income for the future. A deferred annuity delays payouts until a future date, giving your money time to grow before you begin to draw on it. While annuities may not be the right fit for everyone, they are one choice people may consider when thinking about funding their future.

How annuities work

To help understand what an annuity is, it helps to see how they work. An annuity generally has two stages: accumulation and payout.

The accumulation period begins when you put money into an annuity and continues until you are ready to begin receiving regular payments. Contributions can be made as one lump sum or through a series of smaller payments over time. During the accumulation period, the money may grow based on interest rates or investment performance, depending on the type of annuity you choose.

The payout period is when the annuity begins making regular payments back to you. These are also known as distributions. Payouts may last for a set number of years or for the rest of your life, depending on the contract.

Kinds of annuities

There are several types of annuities, each designed to work a little differently. Understanding the basic types of annuities may help you see how they fit with different financial goals.

Fixed annuity

A fixed annuity provides predictable growth — your account earns income based on a fixed rate.

Variable annuity

A variable annuity offers a wide variety of investments, similar to mutual funds. Its account value fluctuates based on the performance of the elected investments.

Indexed annuity

An indexed annuity combines the concepts of fixed and variable annuities. The interest earned is tied to a market index, like the S&P 500. It may provide some protection from losses, but returns are often capped at a certain amount.

The benefits of annuities

Often, people consider annuities because they may provide benefits that other savings tools don’t always offer. Some possible advantages include:

Guaranteed retirement income

One of the biggest appeals of an annuity is the idea of steady income. Regular payments from an annuity could help cover everyday costs during retirement.

Potential tax advantages

Money invested in an annuity may grow on a tax-deferred basis. This means you might not owe taxes on the growth until you begin taking payouts, helping savings grow faster than in accounts where taxes are paid every year.

Protection against market volatility

Certain types of annuities, like fixed annuities or index annuities, are designed to help shield savings from big changes in the market. This kind of protection could be reassuring for those who prefer more predictable growth.

Considerations and drawbacks

While annuities can offer some advantages, they also come with some challenges you’ll want to consider.

Fees and costs

Annuities may have fees attached, like administrative costs or costs tied to investment options. These fees could reduce overall returns over time.

Liquidity concerns

Money placed into an annuity isn’t always easy to access. Taking funds out early may result in surrender charges, which are penalties for withdrawing funds before the end of the agreed-upon period. This could make annuities less flexible compared to other ways of saving for retirement.

Potential downsides

Depending on the type of annuity, growth may be limited by caps, or payments may fluctuate with the market. This means the stability you expect could vary depending on how the annuity you choose is structured.

Is an annuity right for you?

Deciding whether an annuity makes sense for you depends on your personal situation. When you're considering your options, think about:

Your financial goals

If your main goal is steady income later in life, an annuity may be one option to consider. But if flexibility and easy access to your money are most important, you might find some of the rules around annuities less appealing.

Your age and retirement plans

Because annuities are often used to support retirement income, they may be a better fit for people who are closer to retirement or already thinking about long-term planning. Younger savers might prefer options that offer more flexibility and access.

Get guidance from professionals

Since annuities can be complex, many people choose to talk them through with a financial professional before deciding. A professional can help explain how different types of annuities might align with your specific plans.

An annuity isn’t a one-size-fits-all solution. If you’re interested in learning more, TruStage™ could help. Explore annuities.