What to Know About Annuities: Definition, Fees, Rates

Annuities are complex financial products, usually used to supplement income in retirement. You can think of them as insurance-backed investments. Essentially, you pay an insurance company a set amount in premiums. Those premiums are then invested, and you can collect money later from your annuity either in a lump sum or on a periodic basis.

There are different types of annuities. Depending on which type you purchase, you may get a guaranteed income or may be able to get more hands-on with the investments, which can impact your eventual returns. We’ll review different types of annuities, how they align with different risk profiles, fees to keep an eye on and where you can find current rates.

What is an annuity, and how does it work?

An annuity is an insurance product with an investment element. When you purchase an annuity from an insurance company, you enter into a contract in which you agree to pay premiums — either monthly or as an upfront amount — in exchange for future payment. These payments may begin immediately or at a set date in the future.

Most people buy annuities to establish a regular source of income in retirement, receiving payments on a set schedule. However, you can also opt to take your annuity payment as a lump sum instead of in regular installments. Much like a 401(k) investment, the money in your annuity grows without being taxed until you take a distribution, at which point any earnings are taxed at ordinary income rates. If you take distributions before age 59½, you may face a 10% penalty.

You’ll also want to watch out for surrender charges. You’re typically allowed to withdraw a certain amount from your account value every year without penalty, but if you exceed that limit, you may have to pay a surrender charge. Surrender periods usually last for the first six to 10 years after you open an annuity, but you’ll want to check your contact for specifics.

Annuity accumulation phase

During the accumulation phase, you make contributions to your annuity. This money is directed to investments that earn interest as time passes, creating the assets necessary to draw upon during the distribution phase.

Annuity distribution phase

The distribution phase is when you’ll receive your payout. You may receive your payout as one lump sum or spread out into equal payments that occur on a periodic basis, generally monthly.

Payments may continue for a set period of time, such as 10 or 20 years, or until your death and potentially that of your beneficiary, as well.

Types of annuities

The three main types of annuities are fixed, variable and indexed. You may also choose between an immediate or deferred annuity.

Fixed annuity

Fixed annuities guarantee a set amount of interest regardless of how the market performs. This can allow for more dependable payouts, which can continue for a set number of years or your entire lifetime (and potentially that of your beneficiary, as well), depending on your contract.

However, just because the rate is fixed doesn’t mean it’s permanent. Typically, the initial interest rate will last for a set number of years, after which it can change based on current rates.

You can buy fixed deferred annuities with one lump-sum payment or through a series of payments over a longer period of time. Because of their reliable rate of return, fixed annuities are a popular option for people like retirees who want a guaranteed income stream.

Variable annuity

Variable annuities do not have a guaranteed interest rate. Instead, you direct your money — either a single payment or a series of payments — into mutual funds, and your returns will depend on the performance of your investments.

These investments often carry management fees and expenses. Because an annuity is a tax-deferred financial product, you won’t be taxed for any trades you perform. However, your insurance company may charge transfer fees.

A variable annuity often offers the option of adding death benefits and living benefits. Death benefits allow you to give all or a portion of the value of your annuity to a beneficiary after you pass away. Meanwhile, living benefits enable you to secure a guaranteed income for the entirety of your annuity’s term regardless of market performance, even if the term is up until your death. Pursuing either of these optional add-ons will cost you extra in fees.

Variable annuities can entail taxes and charges, so they tend to be best for those with a longer time horizon. Plus, the longer you hold your investments, the better they can withstand any short-term volatility.

Indexed annuity

Indexed annuities are similar to variable annuities in that your returns depend on the underlying investments in your annuity. The difference is that your investments are based on an index. For example, the return on some indexed annuities is tied to the returns of the S&P 500 Index.

There are two basic types of indexed annuities: equity-indexed annuities (EIAs) and registered indexed-linked annuities (RILAs):

• EIAs can act somewhat like fixed annuities as they provide a guaranteed payout. Any amount above that is based on the performance of the indexed investments.
• RILAs, on the other hand, don’t necessarily provide any guarantees, but they do tend to come with a buffer or a floor. With a buffer, the insurance company agrees to absorb a set amount of loss before you incur any loss yourself. If you have a floor, instead, you absorb a certain amount of losses first, and then the insurance company takes on any losses beyond that. The kicker is this doesn’t apply just to losses — it applies to any gains, too. This means that while you might sleep sounder at night knowing your losses are limited, your income growth may be stunted.

Indexed annuities are commonly viewed as a middle ground between the lower returns you tend to see in fixed annuities and the less predictable returns or losses you find with variable annuities. That means indexed annuities may be a good choice if you are shopping for an annuity and assess your risk tolerance as middle-of-the-road.

However, they are highly complicated financial products, so it’s a good idea to seek guidance as you read the fine print before buying.

Deferred annuity vs. immediate annuity

Regardless of whether you have a fixed, variable or indexed annuity, your annuity may fall into either of these categories:

• Deferred annuity: This type of annuity has a longer accumulation phase and surrender period. You receive payments at a set date further out in the future rather than more immediately. Because the time horizon on a deferred annuity is longer, it is often better for those whose goal is long-term growth with the stock market.
• Immediate annuity: In contrast, an immediate annuity has a short accumulation phase and surrender period, with distribution available within the first year. Though available for all types of annuities, an immediate annuity often makes the most sense for fixed annuities, where the return is guaranteed and not dependent on long-term growth.

Annuity costs and fees

The costs and fees you’ll face will vary depending on the type of annuity you purchase. Fixed annuities tend to have the fewest fees, while variable annuities tend to have the most.

Here are common annuity costs and fees you may encounter:

• Mortality and expense risk charge: This fee covers the insurance company’s costs for assuming risk on the annuity. A portion of this fee may be allocated towards commissions.
• Mutual fund expense ratios: These fees are charged by the mutual fund rather than the insurance company. While the average expense ratio is 0.36%, the fees can be much lower, saving you money.
• Contract fee: This is one of the few fees on fixed annuities. The contract fee may be waived if you purchase a large enough annuity.
• Surrender charges: If you withdraw funds from your annuity during the surrender period above the annual allowable amount, you will incur a surrender charge in addition to any tax penalties that may apply.
• Guaranteed lifetime withdrawal benefit fees: A guaranteed lifetime withdrawal benefit (GLWB) rider gives you the ability to claim a set annual amount for the duration of your annuity up to a lifetime max. This rider comes with an additional fee.

Where to find annuity rates

If you’re looking at a specific annuity, you can find rates listed in the contract offered to you. Many insurers also share their current annuity rates on their websites.

Bear in mind that payout rates are only set for certain annuity products. Fixed annuities and annuities with additional GLWB riders have set payout rates. Meanwhile, your rate on an RILA may be constrained by its buffer or floor. EIAs have set rates, too, though you may earn more depending on how your investments perform.

For variable annuities, on the other hand, your investments determine the end rate.

The annuity contract is also the best place to look for fee disclosures. It’s wise to sit down with a financial professional — ideally, one who doesn't work on a commission basis — to help you fully understand the annuity’s rates and fees. How these two line items interact will impact how much you ultimately receive during the distribution period.