Annuities 101
This article is intended to serve as a comprehensive intro to understanding how annuities work and what they can offer you.
For convenience, each major section is also split off into its own article which you can access from the following table of contents:
What's an Annuity? Without the Jargon
In English, an annuity is what happens when you give someone a large amount of money, and they promise to give you a check every so often from that money later. Kind of like getting paid just because you had a lot of money at one point.
Translating Annuities back into Jargon
To be more specific, and legally correct, let’s take that knowledge and go back into finance speak. An annuity is when you make a contract with an insurance or investment company (they’re the ones who make these things) with the understanding that you’ll give them money for some period of time, and later on the company will gradually give you money back.
The time in which you give money is called the accumulation period or phase.
The time you get your money back is called the annuitization period or phase. (It’s so jargony my word processor doesn’t think it’s a real word!)
There are tons of things that can change between different annuities. Such as when money transfers, how much money you get and why, and a slew of other options and features that you can add onto it! We’ll get into each of these specific features and topics in later articles.
For now, let’s keep to annuities as a general concept.
How does an annuity work, really?
You’re trying to make money, the company is trying to make money, and the middle man is trying to make money. So how is this split up?
Your “goal” with an annuity, is to live. Simply follow the rules of the contract, usually not to take any cash out too early, and live long enough to get every easy check you can out of the company.
So if you want the most out of your annuity, be sure to take care of yourself!
The company meanwhile, wants you to pay your fees, and it generally structures the instrument so that they get a little bit of profit from those fees by taking a guess at how long you will live to claim your checks. They're usually great at this guess across all their clients on average, so a few people living well beyond what was expected won't bankrupt the company.
Finally there is the “middle-man”, the agent or 3rd party that transacts the annuity contract by connecting you with the company. They are usually paid a commission, by the company, off the total assets involved.
What’s the point of an annuity?
For companies, the purpose of the annuity is to make money off the sums and fees placed in and associated with the instrument. Their actuaries are great at predicting how long most people will live for, and will simply structure the product according to that information so they can make a profit. Obviously they’re not always correct, but by balancing insurance policies with annuity policies these companies can still regularly come out with a profit, even if they are wrong sometimes.
The goal of an annuity, for the purchaser, is to have a regular stream of income over some set period of time. Usually this is for the purpose of having an income for retirement. Ideally this sum of money will be worth more than the money you originally put in.
Main Types of Annuities
While there are many different kinds of possible annuities, as mentioned in our previous article here, some may even say new ones are created every day. There are a few key things that all annuities address in kind, and for our purposes will refer to as the main “types” of annuities that exist.
Timing of Payments:
When you pay into the annuity is obviously a key concern, not everyone can put up $100,000 in a heartbeat. Although for those that can, there’s an annuity for them too.
Immediate Annuities
These are paid for in a single transaction, a “lump sum” with all the money paid up front. Although in doing so with the understanding that you will immediately begin getting payments as soon as possible. So if you are to receive payments monthly, you get your first check at the start of the next month.
Obviously, if you want or need the income of an annuity right away, then this is a good type of annuity to select.
Deferred Annuities
This type is noted by the fact they are, well, NOT immediate! You get your checks at some later date, for example, 20 years in the future. How you fund this annuity is up for negotiation as well. Whether you decide to pay a single large amount, now and forget about it until it starts paying you. Or you slowly fund the account with monthly, quarterly, or annual payments over time.
In the latter case, it may also be of importance how they are “counted”. As in whether you put in payment at the “start” of a cycle, or at the “end”. The difference is negligible and tends to be a math quirk, and that will be explained in our nerd’s math article for all the details on how annuities are calculated.
Deferred annuities are good if you can wait on the money. A key benefit from using deferred annuities is that they benefit from compound interest, growing the annuity until payout. If two people put in the same amount of money today for an annuity, the person with the deferred annuity would receive a larger payout than the one with the immediate annuity.
NOTE: There is a tax penalty of 10% if you take money out of an annuity before you are the age of 59 and a half years old.
Timing of Checks:
This bit doesn’t usually count as a “type” in the larger industry, but for clients it’s an important part of most contracts nonetheless. You can choose to receive your checks from the annuity at a given interval, usually monthly or yearly.
Or, you can choose to receive the annuity as a lump-sum amount for your own use.
Technically it may be cheaper to receive annual payments, since there is less “work” involved as fewer checks need to be sent out and fewer balances or accounting tables to check on the company’s part. Although conversely, human beings are known to be terrible with suddenly receiving large sums of money like you would have under the yearly option, poorly planning out the money over the course of a long year.
Which is best depends on what you think you will need in the future, and how you personally prefer to receive your money.
Basis of Checks:
This is traditionally understood to be the real “meat” of different annuity types. It is how the company determines how much money you are to receive once it starts paying you.
Fixed Annuities
These are set to give you some amount of interest on your money. Similar to a bank CD, you simply receive the stated sum of money you would be owed at each interval.
Variable Annuities
On the other hand, do not have a stable payout, instead the amount you get with each check depends on the performance of investments in a “separate account”. This is a portion of money set aside specifically for these investments. You are considered responsible for your own separate account and how it is managed.
Equity Indexed Annuities
This type is basically a fixed annuities, except it may give you more money comparatively if the stock market (or some other index of investments) does well.
NOTE: Usually indexed annuities have a “cap” on how much you can gain with the market. For example, if the market rises by 20% in a single year, you may only be limited to 5% of that gain.
Fixed and Equity Indexed annuities are good for those who are more concerned with safety and certainty in their returns. You are guaranteed by the company to receive a given rate of interest.
Variable annuities are good for those who are willing to be more involved with their investments in the hopes of achieving higher returns. Or otherwise be able to participate in market actions without a cap.
What are Annnuity Riders? Explained Simply
While annuities have several main types, riders are the all the “extras” in an annuity contract. From details on death benefits, early access to funds, and all other sorts of changes or benefits that aren’t simply explained by a date and number. There are some quirks you should be aware of before continuing on with this article.
- Know that most riders will usually add additional costs to the annuity.
- Distributions from annuities, especially ones in excess of what is “expected” or taken during the growth phase of the annuity, may reduce your total benefits from the annuity and its riders.
- How the company may calculate these different benefits is constantly different, the descriptions below give a basic idea of the “types” of riders. However details on how much they cost or give are best found in discussions with your advisor, and the specific company you are purchasing an annuity from.
- Many of these riders can go by different names from company to company. We attempt to describe each rider as clearly as possible here so that you have a basis to understand the types of riders you may encounter, regardless of what name the company calls them.
The following list is organized alphabetically.
Death Benefits and “Refunds”
If at the moment of your death, “your” money is still present in the annuity in the form of premium payments or initial principal, your beneficiaries will receive that money back after you pass on. Money that exists solely because of investments in the annuity, may not be returned by such a rider.
There are many other versions of this kind of rider, which use different calculations as to what you are owed, when those calculations are done, and so forth.
“Early Access”: Terminal Illness, Disability, and Unemployment
These riders work on “if-then” rules. If you are determined to be terminally ill, disabled, unemployed, or some other condition that impacts your ability to work or your life expectancy; then you are able to claim the value of your annuity early without paying any additional fees or charges.
Guaranteed Lifetime Withdrawal Benefit
An unusual rider in that it allows you to take withdrawals from the annuity without penalty, even though it is technically still growing in value and you otherwise would not be able to do this. Where most annuities have a phase that you can only put in money, and a phase where you can only take out. This rider allows you to choose what happens to the money, regardless of the “phase” it is in.
The idea is that you may need some of the money from the annuity, but still want to see it grow and accumulate in value. With this rider, you can do that.
Guaranteed Minimum Benefit
This rider tends to be used with variable annuities, given that it is based on the separate account. How it works is that if your annuity is ever worth less than the original amount you put into it, the contract will instead be worth that original amount.
There are also versions of this rider that will automatically increase this “minimum” value of your account, either by a flat percentage increase or by the highest value your account was worth at a given time interval (for example, annually).
Guaranteed Minimum Withdrawals
Similar to the Accumulation Benefit, this rider makes it where you are guaranteed to be able to withdraw a set percent of your original principal and premiums for a period of time. Even if your annuity is now worth less than what you originally put in.
Impaired Risk or “Doctor’s Note”
Should you catch an illness or condition that greatly reduces your life expectancy, the payouts of the annuity will be re-calculated to match your new life expectancy.
Income with Period Certain
Period Certain assures you that you will receive payouts for a set amount of time once you have begun to annuitize. If you pass on before these payouts finish, then your beneficiaries will receive the money instead until the period certain ends.
Inflation Adjustment or Gradual Income Increase
Inflation adjustment riders will attempt to match inflation increases, so that your income can keep its purchasing power and you keep your standard of living.
There may be other riders which similarly increase the amount you receive from your annuity payouts over time, while these may not be with the intention of combating inflation, they function the same way.
Life Income
With this the company promises to send a set payment value to you for as long as you live.
Nursing Home and Long-Term Care
This rider will give additional income should you require nursing home care or some other medically necessary long-term care.
Rainy Day and Emergency Withdrawals
In the event of an emergency, you can use this rider to gain access to the money stored in your annuity, at the risk of reduced future payments. Typically there are other limits to this rider such as how much money of the annuity you can take out and for how long this ability lasts.
Spouse and Joint Survivorship
This rider allows you to essentially “share” the annuity, or otherwise have it transfer benefits over to your spouse. Effectively allowing the annuity to continue paying out even if one of you were to pass on.
The math of the annuity can also be adjusted at this point, such as paying out only half as much money for the survivor so that they can benefit from it longer.
More riders and explanations of them will be added to this list as we come to be aware of them, provided they are genuinely a new “type” of benefit and not a mathematical quirk of an old one.
Controversies & Annuities
Let’s not pretend that a web search of the word “annuity” doesn’t come with at least a few articles pointing out controversies associated with the concept. Nor that there aren’t plenty of horror stories out there about people who put money into them, with insurance companies going bankrupt or bad-actors who manage to siphon someone else’s hard earned money out through a legal loophole.
I believe you have the right to know about these criticisms and controversies, because it is your hard-earned money at stake and that you are smart enough to know what is best for yourself. I will not be another broker who pretends that these things don’t happen.
Here I am going to go over the main criticisms that have been directed at annuities over the years. As well as how to protect yourself against such bad events.
Given this information, other articles available on this website, and conversations with professionals, I hope you will be properly equipped to make the best possible decision for your financial life.
Why am I spending money, to not access my money?
This criticism against annuities focuses on the high surrender charges and fees associated with annuities. Compared to investing normally in say, a low-fee mutual fund, where you also get the benefits of being able to pull out your money within a reasonable amount of time, without losing a significant portion of what it is actually worth.
Many argue that annuities are overall less profitable than simply cutting out the insurance company and investing in funds directly, and you get to actually access all of your money without having to wait. Why on Earth would someone instead put those same funds into an annuity?
Mutual Funds Don’t Have Guarantees
While a valid criticism, it is one that rests on a misunderstanding of what annuities are meant to do. Yes, variable or index annuities have a relationship to investing and the idea of having gains or growth in favor of the owner.
However, the main purpose of the annuity as a financial tool is to ensure that you, the owner of the contract, will have a stream of income in your later years as desired. It is not intended for you to experience the highest amount of gain possible, there are other tools better suited to that purpose.
Markets go down in volatile times, and while it is historically true that the stock market has more often than not increased over the decades, history is not a predictor of future performance. Nor does it help to say “well the market is usually in an uptrend” when you are the person who needs to sell at a loss.
Money which is not needed today, but will be needed to pay for essential items in the future, is typically the “right” kind of money to put into an annuity. Rent and food money should never go into a financial instrument that requires it be locked up for years before you see a return. Nor should “risky” or speculative money that you hope will have explosive returns, there are more efficient tools for that.
Annuities are a retirement instrument for when you do not, or cannot, work anymore. And the benefits from your 401(k), IRA, Social Security, and other such tools may not be enough to cover the medical and living costs you expect to see in the future. The higher costs of annuities are intended to cover these certainties on behalf of the insurance company, so that you don’t have to worry about your future.
An analysis as to how much you would need to put away, and into what type of instrument, is a conversation best had with a professional advisor.
Crooked Salespeople and Companies
Although, that leads us into the next, and more dastardly controversy of annuities. What can you do when companies and salespeople hide behind alien legalese, mismanage your money, or simply go bankrupt and cannot pay you back? There are many horror stories of people who lose money to careless or malicious agents in the industry.
Unfortunately, one does not have to look far in any part of the financial world to uncover corruption. The “buy it and forget it” nature of annuities particularly lends itself to bad practices, as it may be long too late to fix any wrong-doing by the time the owners of the annuity find out.
How to Protect Against Human Behavior?
It can be difficult to predict or even tell when someone, who is in a position of power and knowledge, may use that position against you. Much less how to protect yourself when it is already happening, as it is difficult to summon a legal case when the bad-actor has already taken a good deal of wealth.
Thankfully in the internet age, old “gut instinct” can be supported by reviews of the agents or company in question, how long they have been in the business for and what their overall track record has been like. Searching a legal or corporate name can uncover a wealth of data on that person, revealing whether or not they have a history of malpractice to begin with.
Typically, those entities who have been in the business for decades, if not longer, and lack any notable offenses are ideal ones to consider doing business with. Had they structured their contracts poorly, they would have already been bankrupted in trying to fulfill the payouts of earlier waves of annuity owners. It is also unlikely that they would continue to receive business if the public perceived them as being untrustworthy or corrupt.
Of course, the more cynical reader may point out an earlier quote from this very article. “History is not a predictor of future performance”, the irony does not escape me. Some good people and companies do still manage to go bad, it is always a terrible thing.
Although, it makes more sense to work with a person who is known for good behavior, than one who is known for nothing at all, or known for something even worse.
Life is always risky, good investing is about managing and minimizing that risk.
When in doubt, ask questions, and hold people accountable for the job you are paying them to do. You are your own greatest protector, and I believe you have a right to know what is going on with your money and investments.
Who Should Have an Annuity?
Not every investment idea or tool is for everyone, in the same way you wouldn’t turn a screw with a hammer or wear pajamas to an important meeting. An annuity is for people who need its specific functions and are able to reasonably afford it. I will go over those details in the following sections.
What Is An Annuity’s Purpose?
As discussed in a previous article, an annuity is primarily designed to assure yourself that you will have an income at a later point of your life, based on an insurance company’s guarantee to pay you that income. Another point of view to look through, is that of life insurance. Where life insurance is meant to leave an estate for your heirs to inherit, an annuity is for you to enjoy that wealth and estate while you are still alive.
To this end, if you are not at all worried about having enough income in your future, then annuity is likely not ideal for you. For those who are concerned about their ability to fund their future, it is worth to at least consider this investment tool.
How Old Should I Be To Consider An Annuity?
Some companies may limit the age at which someone can purchase an annuity, but technically there is no limit to when an individual can purchase and begin paying into an annuity. This financial tool is usually purchased by those approaching retirement, and is funded by a sizable sum of money they have built up over the years to assure they will have income for their remaining years. Younger individuals typically do not have the ability to afford annuity deposits, and are generally focused more on wealth building than on preserving what they currently have.
While age is certainly a factor in deciding whether an annuity is a good investment choice for you, your personal goals and current financial situation are also important to consider.
How Much Money Should Be Set Aside?
In short, the money set aside for an annuity is whatever will be enough money to afford you the lifestyle you want to have in your retirement, but will not impact your current standard of living today. Money for bills and rent today, and “rainy day” or emergency money, is not money that should be placed into an annuity.
Nor should you ignore other possible sources of income in the future such as social security, pensions, 401(k)s, and IRAs.
How much you personally place into an annuity should be based on the how much you want to have as an income in the future, minus income from other sources, and adjusting that future value to its present day value. A full article on the maths of this process will be presented later, so you can have an idea on what you may need to invest to reach your financial goals.
As always, do speak with a professional before coming to any major investment decisions.
What About Annuity Riders?
Most riders change the math on how the value of the annuity is calculated, or may offer more income based on certain events occurring in your life. In regards to these types of riders, consider whether or not you personally would need, can afford, and would feel more secure having those riders. You can read up on more details in my article about riders here.
One type of rider I feel is worth noting, is guaranteed benefits for variable annuities. While your investments may be subject to market risk, you are guaranteed to have your annuity equal at least as much as you originally put into it, even if your investments go to 0. The guaranteed benefits can be applied to your received income, or even as a death benefit so that you can pass your money onto your heirs if there is still paid-in value in the annuity.
DISCLAIMER: All guarantees are based on the claims paying ability of the issuing insurance company.
Financial Math Geekery
Be warned, this portion is very technical and I cannot promise that it will be without jargon or can be easily grasped. Nonetheless, I will try my best to explain the mathematical concepts involved in annuities.
Know that for this article I round all values to the 2nd decimal place. (0.01 ← This much) So the numbers involved may not be 100% accurate, at the expense of not taking up the entire webpage! The differences will be negligible for these examples however.
Present and Future Value
The most basic equation we are basing these mathematics on is the Present Value equation, which determines how much a future sum of money is worth today. After all, a $100 today can be worth far more than $101 tomorrow, if you know what you’re doing with that money. The equation is as follows:
PV = FV / (1 + r/m) ^ (m*T)
PV = Present Value, how much the money is worth now
FV = Future Value, how much money is involved in the future
r = Annual interest rate, how much the money grows per year
T = Total number of years involved
m = Number of compounding periods in a year, having your money grow at a monthly rate can result in more income than having that same cash grow at an annual rate
To find the Future Value of a present sum of cash, you simply “move” the bottom of the equation next to the PV value. So it would look like:
FV = PV * (1 + r/m) ^ (m*T)
To give a basic idea of how these equations work, say you want to have $10,000 after 5 years after investing that money for a 3% return, how much money do you need to start?
$10,000 / (1 + 0.03/1) ^ (1*5)
= $10,000 / (1.03)^5
= $10,000 / (1.16)
= $8620 = Present Value today, invested at 3% interest for 5 years, to have about $10,000 in 5 years.
Why does this work?
This equation is generally true when we break it down.
In year 1 we have $8,620. It grows by 3% and in year 2 it becomes $8878.60. The interest rate however applies to the new value, not the original one, so in year 3 it is $9144.96, the money is growing faster over time as more money is affected by the interest rate.
This is the power of compound interest, while the rates and numbers involved may start out small, over time they can grow large if they are undisturbed. Even though all you’re doing is just multiplying in an interest rate each year.
So $8620 * 1.03 * 1.03 * 1.03 * 1.03 * 1.03 = $10,000
To make this easier to look at, we use exponents, therefore:
$8620 * 1.03^5 = $10,000
Present Value * (1 + interest rate per period) ^ (number of periods) = Future Value
Note: Because I am simplifying the math by only going to 2 decimal places, the actual answer of this particular equation is about $7 off. This goes to show just how sensitive interest rates are on the value of money, fractions of fractions can be worth a lot more than just a cup of coffee!
Also, the reason we +1 the interest rate, is because multiplying by decimals otherwise causes numbers to shrink which is clearly not happened. A value of 1.03 indicates that the value increases by 3%, but 0.03 would tell us to shrink the value to 3% exactly!
What if Money is Coming In/Out Regularly?
This math situation is called an annuity, given that it is the most common time this situation happens! In this case:
Annual Payment = FV / { [(1 + r) ^ (T * m) – 1] / r }
FV = Annual Payment * { [(1 + r) ^ (T * m) – 1] / r }
Back to our 3% interest, 5 years to $10,000 example, how much would need to be spent as an annual payment to reach this goal?
Annual Payments = $10,000 / { [(1 + 0.03) ^ (5 * 1) – 1] / 0.03 }
= $10,000 / { [(1.03)^5 – 1] / 0.03}
= $10,000 / { [1.16 – 1] / 0.03 }
=$10,000 / (0.16/0.03)
= $10,000 / 5.34
= $1875 = Annual Payments over 5 years, invested at 3%, to reach $10,000
Why Does This Work?
The reason payments is more complicated of an equation than a single sum investment, is because of the fact there are multiple amounts of money experiencing different things.
That first $1875 is going to have more time to grow at 3% than the second, which will have more time to grow than the 3rd, and so forth. Rather than try to calculate each of these individually in a wild goose chase to find a correct answer, we come to find the correct payment value by finding the total interest rate change and divide that by the originally stated rate.
Or to put it simply, we find out what would be the total increase of 3% interest over 5 years (about equal to 16% interest in a single year), and then divide that number by the original 3%. This gives us a value we can use to divide into the original target of $10,000, telling us how to evenly “split” that future value over 5 years. Even though $1875 * 5 = $9375, the 3% interest will cover the difference.
What About Paying At the Start of a Period?
The difference between money exchanging at the start of a period, versus the end of a period, is that the money in question will be affected by interest longer. Although, this difference is not usually enough to be the same as having the money in for an extra period, but it is enough to be worth calculating.
How we find the difference is to simply multiply that final “divisor” by the interest, and this “shifts” all of the interest periods to account for that extra bit of time each one has. To see it as a formula:
Annual Payment = FV / ( { [(1 + r) ^ (T * m) – 1] / r } * [1+r])
FV = Annual Payment * ( { [(1 + r) ^ (T * m) – 1] / r } * (1+r) )
What If I Paid A Sum, and THEN Put in Regular Payments?
In this case, you would add both equations. So say you have $5000 today, but still want to reach $10,000 in 5 years at 3% interest, assuming funds are invested at the end of each period. How would that look like?
FV = $5000 * (1+0.03)^5
= $5000 * 1.16
= $5796.37 = Value of that $5000, 5 years in the future at 3% interest
Now we would need to subtract that value from the total we want to have after 5 years.
$10,000 - $5,796.37 = $4203.63 unfunded future cash, let’s fund it with annual payments.
Payments = $4203.63 / { [(1.03)^5 – 1] / 0.03}
= $4203.62 / (0.16/0.03)
= $4203.62 / 5.34
= $787.19 per year, at 3% interest, in addition to $5,000 initial deposit, will achieve $10,000 in 5 years.
Why This Matters, and a Word of Caution
It is important to understand how these maths work because they can guide us to make prudent investment decisions, and to not misunderstand your current financial situation.
However, bear in mind that real world situations can be much more complicated. Whether it be fee payments in addition to interest gains, inflation, inconsistent gains in your finances, or other risks such as emergencies in your personal life or geo-political events.
These equations are to financial goals and economic understanding, as a highschool equation of gravity is to physics, and cannot be considered a substitute for true expertise or understanding of any given financial situation.
Congratulations!
You've reached the end of this article, and in doing so you have put more effort to addressing your financial future than most people even consider in their entire lives! Now your next step, is to act on your dedication and grit.
If you would like to start investing with annuities today with 30 years of experience to help guide you, call me at 203-956-0289. You can also send an e-mail to wward@1stallied.com. Hope to hear from you soon!
