What Are Annuity Rates and How Do Annuities Work?

(The Street) -- Annuity rates represent the total amount of an annuity payment that will be paid out to an annuity recipient.

An annuity rate can't be paid out until the annuitant - almost always an individual looking for a retirement income stream - pays a lump sum to the annuity provider, which in turn invests the money for long-term appreciation.

Once the annuitant reaches retirement and starts cashing out on the annuity, he or she receives regular annuity payments, tied to the agreed-upon annuity rate when both parties signed a contract.

As part of that contract, the annuity provider (usually an insurance company) must pay at least the guaranteed annuity rate that was agreed upon by both parties. In that sense, an annuity rate is a formula used by the provider to calculate the amount of money paid out to the recipient in retirement.

What Is an Annuity?

To understand annuity rates, you must first understand annuities, especially the common forms of annuities offered.

Annuities are investment vehicles offered by financial services firms that help an individual or couple preparing for retirement achieve a regular stream of income once in retirement.

Annuities may not be the primary income vehicle for retirement savers once they're out of the workforce, but they can represent a valuable source of cash flow once the annuitant is retired.

As noted above, the annuity kicks off with a contract signed by the annuity provider and the recipient.

In return for either a lump sum payment or a series of regular payments, the annuitant earns regular cash payments from the annuity provider, usually down the road when the annuitant is either close to, or is actually in retirement (although payments may come sooner, depending on the annuity contract language.

What annuitants look for from an annuity is straightforward - they want a regular stream of reliable payments, preferably at or near retirement age. Ideally, an annuity is used by the recipient to supplement the primary sources of retirement income - a 401(k) plan, an individual retirement plan (IRA), a self-employment retirement plan, or a company pension.

Like a 401(k), annuitants can start receiving plan payouts without paying a penalty after the age of 59½. Also like a 401(k) plan, annuities can be uniquely created to meet the desired needs of an annuity recipient.

That's why annuities and inherent annuity rates come in two common forms:

Immediate Annuities

So-called immediate annuities enable recipients to pay a lump sum of money to an annuity provider and convert that payment into a cash income stream. There is no accumulation period with immediate annuities, and they must be funded with lump-sum payments.

Immediate annuity payments start within one year of the annuity purchase date. Immediate annuities have decided tax advantages, making them popular with retirees who own a defined benefit pension plan. In that scenario, only money earned on annuity investments is taxed with an immediate annuity, while the actual lump sum annuity payment goes untaxed.

Immediate annuities are also popular in legal payouts, where the payer and payee agree that any lump sum payout resulting from a court case can be disbursed on a regular (such as monthly) basis, thus giving the payee a reliable source of income going forward - often for life.

Deferred Annuities

Deferred annuities are just what they sound like, annuity payouts made after a lump sum contribution that are doled out well into the future, after the annuity's accumulation period is complete.

That period could be 10 or 20 years or more, depending on the annuity's contract.

Like immediate annuities, taxes are only levied on the earnings component of a fixed annuity, and are not taxed until the annuity earnings are distributed.

It's worth noting that any annuity payouts take before age 59½ are subject to a 10% IRS tax penalty, although certain exceptions (like ill health) do apply.

What's in It for the Annuity Provider?

What annuity providers get out of the deal comes with some controversy.

After all, at first glance it's difficult to see how an insurance company makes money on an annuity. In an annuity contract, the amount of cash paid out by the provider is more than the annuitant steers into the annuity.

Some of that payout comes from capital appreciation, i.e., the investment vehicles (i.e., usually stocks and funds) used per the contract generate revenue in excess of what the annuitant put into the annuity in the first place. Even so, nothing is guaranteed in the financial markets, and sometimes little or no gains are made at all.

Since the annuity provider has to honor the contract and payout the required amount of payments, no matter how the underlying investment vehicles tied to the annuity perform, the annuity company has to make its profit elsewhere, and that's where fees enter the picture.

The reality is that annuities are rife with fees and charges, to the point where many consumer advocates wonder if annuities are worth the trouble for retirement savers.

The charges mandated by annuity providers are many - but these are the most prevalent:

Insurance fees. Insurance charges, also known as mortality and expense fees, run about 1.25% of the total value of the annuity under contract on an annual basis. These fees cover the annuity provider's cost of producing and managing the annuity, and are also viewed as fees against the guarantees made by the provider as stated in the annuity contract.

Surrender fees. These charges arise when an annuitant wants to get out of the contract early. While surrender fees do diminish the longer the annuitant adheres to the contract, they can be costly if you want out. Insurance companies are known to charge 7% of the annuity's value for you to leave early in the first year of an annuity, so having second thoughts can be expensive with annuities.

Investment management fees. Annuitants may wonder why they have to pay fees on both the management and investments side, but that's usually the case. Aside from the annuity management fee, annuitants also must pay an investment management fee, too.

This fee represents the fees annuity providers pay to mutual fund or other investment vehicle firms, for the right to put them into the annuity.

Investment fees vary, so it's advisable to check your annuity contract to see exactly what you're paying for investment management fees, before signing on the dotted line.

Rider fees. These charges are made on riders, i.e., optional guarantees that some providers make available in their annuities. Typically, riders are tacked on to an annuity to guarantee that the annuity's payments will stay even or ahead of inflation.

The riders increase the payouts, usually by between 1%-5%, but that payout protection comes at a cost of adding a rider onto the annuity in the first place.

Three Reasons Why You Would Need an Annuity

Not everyone needs an annuity but in the following scenarios, an annuity could work for you.

You favor regular payments. Getting regular payments is perhaps the most popular component of an annuity. For retirees - or near-retirees - who are used to getting a paycheck every two weeks or so, continuing to get a paycheck in retirement is highly desirable.

They're tax-advantaged. Annuities also offer tax benefits to long-term savers. With an annuity, any cash you move into an annuity is tax-deferred, meaning you don't pay taxes until you withdraw the cash in retirement, when you're likely to be at a lower tax rate.

Guaranteed returns. Some annuities, most notably fixed annuities, offer guaranteed payments, so no matter what happens, you won't lose any money. In fact, most fixed annuities guarantee you'll make money on the investment, albeit at a likely low rate.

Three Reasons You Shouldn't Get an Annuity

Don't opt for an annuity if these conditions arise - they may negatively impact your personal financial situation.

You're paying high fees. Annuities are controversial because of their rampant fees and charges. From administrative fees to high surrender charges, annuity fees can mount up. If you're fee-averse, but looking for a steady stream of income in retirement, annuities may not be for you.

You're not earning much on your investments. Compared to investments in stocks and stock funds, returns can be low on annuity investments. Often, cap limits are placed on annuity returns, so you may be losing out if you're looking to keep pace with the stock market.

Annuities are expensive to leave. If you don't like your annuity experience, and want to get out and move on, expect to pay a heavy price to do so. Immediate annuity payments are often locked in and you can't take them out (although you may be able to move them to another annuity.) Also, high surrender charges make leaving an annuity a pricey proposition.

It's never too late - or too early - to plan and invest for the retirement you deserve. Get more information and a free trial subscription to TheStreet's Retirement Daily to learn more about saving for and living in retirement. Got questions about money, retirement and/or investments? We've got answers.


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