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What is an Annuity And How Do They Work?

An annuity is a contract between an insurance or financial company and you, where you agree to make a series of payments for a predetermined amount of money during a set period of time. In return, you receive a lump sum or regular disbursements once the annuitization phase has been reached.

These products are sold, issued, and distributed by financial institutions. They invest funds from individuals and are typically used as income for retirees. Annuities provide a stream of payments for their remaining lifetime.  

How Does An Annuity Work?

Think of annuities as if they are insurance contracts. You will pay a set amount of money today, or on a recurring basis, and in return you will receive a lump-sum or stream of income in the future. The concept sounds simple enough, however annuities can often be complicated.

There are various types of annuities, but they all have one thing in common, they pay out future payments for your retirement income. 

Different Types Of Annuities

Before you decide to invest in an annuity, you should familiarize yourself with the different options to choose from. Take time to consider how each annuity works, what you can expect from each option in the future, and your goals. 

Fixed Annuity

Who doesn’t like something simple and straightforward? A fixed annuity is just that. When you invest in a fixed annuity, the insurance company will “lock in” a set interest rate. Your money will not be tied to market rates.

There are two different types of fixed annuities, intermediate fixed-income annuities and deferred income annuities.

Intermediate Fixed-Income Annuities

This annuity type requires you to pay a lump sum up front in return for a guaranteed stream of income for a set period of time. Depending upon your contract, this stream could extend for life. The payments on intermediate fixed-income annuities typically start immediately.

Deferred Income Annuities

This annuity type is similar to intermediate fixed-income annuities, but instead of receiving the payment immediately, the income is deferred. Your income stream of payments could begin months or years down the road. During this accumulation period, your annuity will start accumulating interest. You are also able to make extra payments to increase future income if you so desire. 

Variable Annuity

Now onto a more complex annuity. Variable annuities are more of an investment than an insurance product. When you set your annuity, you will decide which investment option you want to direct the payments toward.

Then, the amount of your payments and return on investment will determine your future income stream. While this type of annuity can provide you with a higher payout and return, it can also result in a lower-than-anticipated income stream depending upon market volatility. 

Single Life Annuity

A single life annuity, also commonly called a straight life annuity, has one of the highest monthly payout options, in terms of annuities. And while this may seem attractive to many, the drawback to single life annuities is that the income stream ends with the annuity holder dies.

However, a single life annuity can provide a single person with monthly income for as long as they live. They are a great choice for people who are unmarried, or for couples with other retirement income that can support the surviving spouse.

Joint And Survivor Annuity

A joint and survivor annuity on the other hand provides payments that are slightly lower than a single life annuity. However, the payments last longer, as they are guaranteed for the lives of the contract holder and secondary annuitant. There are even provisions that can make payments to a third party in the event both annuitants die before all principal payments have been made. 

Qualified Employee Annuities

A company/employer can purchase a qualified retirement annuity for its employees, if the plan meets the IRS code requirements. This financial tool is purchased with pre-tax dollars, and taxes must only be paid when you receive your distributions. Common qualified employee annuities include 401(k) plans, IRA accounts, Simplified Employee Pension, 403 (b) plans, and tax-exempt savings plans. 

Tax-Sheltered Annuities

With a tax-sheltered annuity, employees can make pretax contributions to their retirement accounts from their income. Like qualified employee annuities, the taxes will need to be paid when you receive your distribution.

Annuity Pros And Cons

There is much to consider when planning for your retirement, and looking at the benefits and downfalls of annuities can help you on your way. After you have determined which annuity option is best for you, take a look at the pros and cons to make sure it is the best investment choice for your retirement.


There are many reasons that annuities are an attractive option for retirees. This includes:

Income For Life

The most compelling reason to select an annuity is that you will have the stream of income for life. While other investment options can provide you with high returns, unless your nest egg is extremely large, you likely will need more help supplementing your income. An annuity can provide you with just that. It can supplement your social security income, even if you live to an old age.

Guaranteed Rates

While variable annuities depend on the market performance, fixed annuities can provide you with peace of mind for your rate of return. If a senior is looking for a stable, predictable income stream, fixed annuities are a great solution.

Deferred Taxes

With other investments, you have to pay taxes once it reaches maturity. With annuities, your tax is deferred. Until you withdraw your funds, you will not have to pay taxes.


With all things, there is always a pitfall or two that comes with the great benefits. The most common complaints about annuities are the lack of liquidity and hefty fees. Compared to other investments, you can be faced with a sizable fee. And there are not a lot of options for investors if they want to withdraw their money early after they’ve signed the dotted line. 

What’s Next: Hiring a Financial Advisor or DIY Financial Planning

Working with a financial planner can provide you with a roadmap to reach your retirement goals. Annuities are a great option to secure a steady retirement income stream. But they are just one piece to your financial strategy.

However, many people choose to DIY their financial planning, and that’s just as valuable of an option. If you choose to go this route, take time to set aside each week to review your financial planning, adjust, and invest as needed. Don’t hesitate to use financial planning software that can make the process easier and be sure to zero in on your budget and spending.