Understanding Annuities: How to Acquire One

Quick answer

• Annuities are insurance contracts that can provide a stream of income, often for retirement.
• To acquire an annuity, you typically work with a licensed insurance agent or financial advisor.
• You’ll need to decide on the type of annuity (fixed, variable, indexed) that best fits your goals.
• Consider your risk tolerance, income needs, and how long you want the income to last.
• Understand the fees, surrender charges, and tax implications before purchasing.
• Consult a qualified financial professional to ensure it aligns with your overall financial plan.

Who this is for

• Individuals seeking a predictable income stream during retirement.
• Those looking for a tax-deferred growth vehicle for their savings.
• People who want to protect a portion of their retirement savings from market volatility.

What to check first (before you act)

Goal and timeline

Before considering an annuity, clearly define what you want to achieve and by when. Are you looking for immediate income, or do you want to defer income for several years? Is the primary goal income security, wealth accumulation, or a combination? Your timeline will significantly influence the type of annuity that might be suitable.

Current cash flow

Understand your current income and expenses. This will help you determine how much you can afford to invest in an annuity and how much income you will need from it in the future. A clear picture of your cash flow is crucial for making realistic financial decisions.

Emergency fund or safety buffer

Ensure you have a readily accessible emergency fund before committing significant assets to an annuity. Annuities are generally long-term investments, and funds locked into them may be subject to penalties if withdrawn early. A robust emergency fund provides a cushion for unexpected expenses without forcing you to break an annuity contract.

Debt and interest rates

Assess your current debt situation, particularly high-interest debt. It often makes more financial sense to pay off high-interest debts before investing in products like annuities, as the interest paid on debt can outweigh potential annuity returns. Check the interest rates on your debts to prioritize accordingly.

Credit impact

While purchasing an annuity doesn’t directly impact your credit score in the way a loan does, the financial decisions surrounding it can indirectly affect your creditworthiness. For example, if you liquidate assets to fund an annuity and then need to borrow money, your credit history will be the deciding factor.

Step-by-step (how to get annuity)

1. Define your retirement income needs

What to do: Estimate how much income you’ll need annually in retirement to maintain your desired lifestyle.
What “good” looks like: A realistic, detailed budget for your retirement years that accounts for essential expenses and discretionary spending.
Common mistake: Underestimating retirement expenses or overestimating other income sources. Avoid this by being thorough with your budget and considering potential healthcare costs.

2. Assess your risk tolerance

What to do: Determine how comfortable you are with investment risk. Are you seeking guaranteed returns, or are you willing to accept some market fluctuation for potentially higher growth?
What “good” looks like: A clear understanding of your personal comfort level with investment volatility.
Common mistake: Choosing an annuity that doesn’t align with your risk tolerance, leading to dissatisfaction or regret. Avoid this by honestly evaluating your feelings about market ups and downs.

3. Research annuity types

What to do: Learn about the main types of annuities: fixed, variable, and indexed. Understand their core features, how they grow, and their payout structures.
What “good” looks like: A solid grasp of the fundamental differences and benefits of each annuity type.
Common mistake: Not understanding the nuances between annuity types, potentially leading to a mismatch with your goals. Avoid this by taking the time to study each option thoroughly.

4. Consult a licensed professional

What to do: Speak with a qualified insurance agent or a fee-only financial advisor who specializes in retirement income planning.
What “good” looks like: Receiving personalized advice based on your financial situation and goals from a reputable professional.
Common mistake: Working with an agent who is not properly licensed or who pushes a specific product without considering your best interests. Ensure your advisor is licensed and acts as a fiduciary.

5. Compare annuity quotes and features

What to do: Obtain quotes from multiple reputable insurance companies for the annuity types you are considering. Pay close attention to the contract details, including fees, surrender charges, and riders.
What “good” looks like: A clear comparison of offers, highlighting differences in costs, guarantees, and potential benefits.
Common mistake: Focusing solely on the advertised rate of return and overlooking hidden fees or restrictive terms. Avoid this by meticulously reviewing all contract provisions.

6. Understand the payout options

What to do: Explore the various ways you can receive income from the annuity, such as a lifetime income stream, a fixed period, or a combination.
What “good” looks like: Selecting a payout option that best matches your projected lifespan and income needs.
Common mistake: Not fully understanding how the payout options work, especially regarding inflation protection or survivorship benefits. Clarify all payout scenarios with your advisor.

7. Review the contract carefully

What to do: Read the entire annuity contract thoroughly before signing. Pay special attention to the fine print regarding surrender charges, fees, and any limitations.
What “good” looks like: A complete understanding of all terms and conditions of the contract.
Common mistake: Signing the contract without reading it or understanding its implications, leading to unexpected costs or restrictions. Take your time and ask questions about anything unclear.

8. Fund the annuity

What to do: Once you’ve chosen an annuity and understand the contract, you will transfer funds to the insurance company. This can be done via check, wire transfer, or by rolling over funds from another retirement account (like an IRA or 401(k)).
What “good” looks like: A smooth and secure transfer of funds according to the agreed-upon terms.
Common mistake: Not understanding the tax implications of funding the annuity, especially if using non-qualified funds. Consult your advisor or tax professional regarding the best way to fund it.

9. Monitor your annuity

What to do: Periodically review your annuity’s performance and ensure it continues to meet your financial objectives.
What “good” looks like: Staying informed about your annuity’s status and making adjustments if your circumstances change.
Common mistake: Forgetting about the annuity after purchase and not reviewing its performance or suitability over time. Regular check-ins are important, especially with variable or indexed annuities.

Common mistakes (and what happens if you ignore them)

Mistake	What it causes	Fix
<strong>Not defining clear goals</strong>	Purchasing an annuity that doesn’t align with your actual retirement needs.	Clearly articulate your income needs, timeline, and risk tolerance before exploring options.
<strong>Ignoring fees and charges</strong>	Reduced overall returns and higher-than-expected costs eating into your principal.	Scrutinize all fee schedules, surrender charges, and administrative costs; ask for explanations.
<strong>Choosing the wrong annuity type</strong>	Mismatch between your risk tolerance, growth expectations, and income needs.	Thoroughly research fixed, variable, and indexed annuities to find the best fit for your profile.
<strong>Not understanding surrender charges</strong>	Significant financial penalties if you need access to your funds before the surrender period ends.	Be aware of the surrender period length and the associated costs of early withdrawal.
<strong>Overlooking inflation risk</strong>	Fixed income payments lose purchasing power over time due to rising prices.	Consider annuities with inflation riders or plan for other inflation hedges.
<strong>Relying solely on an agent’s advice</strong>	Potential for biased recommendations if the agent is not a fiduciary.	Seek advice from multiple sources, including fee-only advisors, and do your own research.
<strong>Not considering liquidity needs</strong>	Funds are locked up, making them inaccessible for emergencies or other opportunities.	Ensure you have adequate liquid assets outside the annuity for unexpected needs.
<strong>Failing to review the contract details</strong>	Being surprised by clauses, limitations, or guarantees that you didn’t understand.	Read every word of the contract, ask questions, and seek clarification before signing.
<strong>Misunderstanding tax implications</strong>	Unexpected tax liabilities upon withdrawal or during the accumulation phase.	Consult a tax professional to understand the tax treatment of your specific annuity.
<strong>Assuming guarantees are absolute</strong>	Not realizing that guarantees are backed by the issuing insurance company’s financial strength.	Research the financial ratings of the insurance company offering the annuity.

Decision rules (simple if/then)

• If your primary goal is guaranteed lifetime income with no market risk, then consider a fixed annuity because it offers predictable growth and payouts.
• If you are comfortable with market fluctuations for the potential of higher returns, then a variable annuity might be suitable, but be aware of its associated fees and risks.
• If you want potential growth tied to market indexes but with downside protection, then an indexed annuity could be an option, but understand its caps and participation rates.
• If you need income within the next year, then a single premium immediate annuity (SPIA) is likely the best choice because it converts a lump sum into income right away.
• If you plan to defer income for many years and want tax-deferred growth, then a deferred annuity (fixed, variable, or indexed) is appropriate.
• If you have significant assets to invest and want to secure a portion of your retirement income, then an annuity can be a useful tool to diversify your retirement portfolio.
• If you are concerned about outliving your savings, then an annuity with a lifetime payout option provides a solution because it guarantees income for as long as you live.
• If you are nearing retirement and want to convert a large sum of savings into a steady paycheck, then exploring annuity options becomes more relevant.
• If you have substantial high-interest debt, then paying off that debt should be prioritized over purchasing an annuity because the interest saved can be a guaranteed return.
• If you don’t have an emergency fund, then building one should be your first priority before investing in an illiquid product like an annuity.
• If you are unsure about your risk tolerance, then start with less complex, more conservative options like fixed annuities or consult a financial advisor.
• If you are considering an annuity for tax deferral, then ensure you understand the tax implications of withdrawals and compare it to other tax-advantaged retirement accounts.

FAQ

What is an annuity?

An annuity is a contract between you and an insurance company. In exchange for your premium payments, the insurer promises to make periodic payments to you, either immediately or in the future. They are often used for retirement income.

Are annuities safe?

Annuities are generally considered safe, as their safety depends on the financial strength of the issuing insurance company. Guarantees are backed by the insurer’s ability to pay. It’s wise to check the financial ratings of the company.

What are the main types of annuities?

The primary types are fixed annuities (guaranteed interest rate), variable annuities (investment sub-accounts, market risk), and indexed annuities (growth linked to an index, with caps and participation rates).

How do I pay for an annuity?

You can pay for an annuity with a lump sum (single premium) or through a series of payments over time (flexible premium). Funds can also be transferred from other retirement accounts like IRAs or 401(k)s.

What are surrender charges?

Surrender charges are fees you pay if you withdraw money from your annuity during a specified period, often the first several years of the contract. They are designed to recoup the insurance company’s initial sales costs.

Can I lose money in an annuity?

With fixed annuities, you typically won’t lose your principal unless the insurance company fails. With variable annuities, you can lose money because the value fluctuates with market performance. Indexed annuities offer some protection but can still have limitations on growth.

Are annuities good for retirement?

Annuities can be a valuable tool for retirement income security, especially for those seeking guaranteed income. However, they may not be suitable for everyone due to fees, complexity, and surrender charges.

What is the difference between an immediate and a deferred annuity?

An immediate annuity starts paying out income shortly after purchase, usually within a year. A deferred annuity grows over time before payments begin, allowing for tax-deferred accumulation.

How are annuities taxed?

Earnings in a deferred annuity grow tax-deferred. When you receive payments, the earnings portion is typically taxed as ordinary income. Withdrawals before age 59 ½ may also incur a 10% IRS penalty.

What this page does NOT cover (and where to go next)

• Specific product recommendations or comparisons.
• Detailed tax advice for specific annuity situations.
• Investment advice for variable annuity sub-accounts.
• Estate planning implications of annuity ownership.
• The financial health and ratings of specific insurance companies.