Understanding Annuities And What Happens At Death

What Is an Annuity and How Does It Work

An annuity is a financial product where you give money to an insurance company, and in return, the company pays you regular amounts of money over time. Think of it as a contract between you and the insurance company. You make a payment or series of payments, and the company promises to send you income later. This arrangement can last for a set number of years or for the rest of your life, depending on the type of annuity you choose.

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The basic structure works like this: during the accumulation phase, you deposit money into the annuity. The money grows over time, often through interest or investments, depending on which type of annuity you own. Then, during the distribution phase (also called the annuitization phase), the insurance company converts your accumulated funds into regular payments. These payments might come monthly, quarterly, or annually.

There are several main types of annuities. A fixed annuity pays a specific amount of money at set intervals. Your rate of return doesn't change, no matter what happens in the stock market. An indexed annuity offers returns tied to a market index, such as the S&P 500, but with some protection if the market declines. A variable annuity allows you to invest in sub-accounts similar to mutual funds, meaning your payments can go up or down based on investment performance. An immediate annuity begins paying you right away after you make a lump-sum payment. A deferred annuity lets your money grow for years before you start receiving payments.

According to the American College of Financial Services, roughly 35 million Americans own some form of annuity. Many people use annuities as part of retirement planning because they create predictable income when you stop working. The appeal lies in knowing you'll receive a certain amount of money regularly, which can help with budgeting and covering essential expenses.

Practical takeaway: Before considering an annuity, understand which type fits your situation. A fixed annuity provides stable, predictable income. A variable annuity offers growth potential but with more risk. An immediate annuity works well if you have a large sum to invest right now and want payments to start quickly. Talk with a financial professional about which structure aligns with your retirement goals and comfort with risk.

Different Types of Annuities Explained

Fixed annuities work like a savings account that guarantees a return. The insurance company promises to pay you a specific interest rate for a set period—typically 3 to 10 years. During that time, your rate doesn't change even if interest rates rise or fall in the broader economy. This predictability appeals to people who want to know exactly how much income they'll receive. Fixed annuities are among the safest annuity options because your principal is protected. If the insurance company fails, state insurance guarantee funds typically cover your money up to certain limits, which vary by state but often range from $100,000 to $500,000 per account holder.

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Indexed annuities sit between fixed and variable annuities in terms of risk and potential return. Your money is invested in a strategy that tracks a market index like the S&P 500. If the index performs well, your returns increase up to a set cap—sometimes 10 percent or 12 percent annually. If the market declines, your money is protected from losses below a certain floor, often zero percent, meaning you might earn nothing that year but won't lose principal. This protection comes with a trade-off: you don't earn the full market returns if the index surges. For example, if the S&P 500 gains 20 percent but your annuity has an 8 percent cap, you'd earn only 8 percent.

Variable annuities give you the most control but carry the most risk. You choose how to invest your money from a menu of sub-accounts—essentially mutual funds within the annuity. Your returns depend entirely on how those investments perform. If stocks rise sharply, you could earn substantial returns. If they fall, your account value falls too. Many variable annuities include optional riders that provide some protection, such as guaranteeing a minimum income regardless of investment performance. These protections carry extra costs, typically 0.5 percent to 1.5 percent annually of your account value.

Immediate annuities and deferred annuities are structured differently based on timing. With an immediate annuity, you give the insurance company a lump sum—perhaps $200,000—and within 30 days, the company begins sending you monthly checks. A deferred annuity lets your money accumulate for years or decades before payouts begin. For example, a 45-year-old might start a deferred annuity, let it grow until age 70, and then begin receiving lifetime income.

Practical takeaway: Evaluate how much control you want over your investments and how much risk you can tolerate. If you want stability and predictability, a fixed annuity may suit you. If you want some growth potential with downside protection, consider an indexed annuity. If you're comfortable with market risk and want the highest growth potential, a variable annuity might work. The timing of when you need income also matters—if you need money soon, an immediate annuity works. If retirement is years away, a deferred annuity provides more growth time.

How Annuity Payments Are Calculated

Annuity payments depend on several factors that the insurance company analyzes using actuarial science—the math insurance companies use to assess risk and calculate payouts. The primary factors are your age, your sex, the amount of money you're converting into income, current interest rates, and the payment structure you choose. Understanding these factors helps you grasp why two people with the same annuity amount might receive different monthly payments.

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Age is one of the most important variables. A 65-year-old converting $300,000 into a lifetime annuity receives a larger monthly check than a 55-year-old with the same amount. This is because the insurance company expects to pay the 55-year-old for a longer period, possibly 30 or 40 years versus perhaps 25 years for the 65-year-old. The longer the expected payment period, the smaller the monthly amount must be to exhaust the funds over that time. For example, using standard actuarial tables, a 65-year-old male might receive roughly $1,450 per month from $300,000, while a 55-year-old male might receive about $975 per month from the same amount.

Gender also affects calculations because of actuarial life expectancy differences. Women statistically live longer than men, so a woman receives a slightly lower monthly payment than a man of the same age with the same annuity amount. This difference is not large—typically 5 to 10 percent—but it's built into the calculation. Some states have regulations about whether annuity providers must use unisex mortality tables, which treat men and women the same regardless of life expectancy data.

The payment structure you select substantially impacts the amount. A "life only" annuity pays you as long as you live, then stops—no payments go to heirs. This structure provides the highest monthly payment because the insurance company has certainty that payments will end at your death. A "life with period certain" annuity guarantees payments for your life and also guarantees that if you die within a set period (usually 10, 15, or 20 years), payments continue to your beneficiary for the remainder of that period. This reduces your monthly payment but protects your heirs if you die young. A "joint and survivor" annuity continues payments to your spouse after you die, which further reduces the monthly amount. For instance, a "life only" annuity might pay $1,500 monthly, but the same annuity with a 10-year period certain might pay $1,425, and a joint and survivor option might pay $1,350.

Interest rates in the broader economy influence annuity calculations. When interest rates are high, insurance companies can invest your money at higher returns, so they can afford to pay you more. When rates are low, payouts are lower. As of late 2023, higher interest rates have made fixed annuities and immediate annuities more attractive than they were in recent years. Someone who deferred buying an immediate annuity for five years during a low-interest period would now receive noticeably higher monthly payments for the same investment.

Practical takeaway: Before purchasing an annuity, request illustrations showing different payment options. Compare the monthly amount for "life only" versus "life with period certain"