Annuities are financial products that can offer you flexible investment strategies to reach your financial goals, both retirement and non-retirement. Although annuities aren’t solely for retirees, they’re a powerful asset when setting up predictable income streams later in life. Buying one today may guarantee you’ll receive monthly payouts down the road.

Read on to learn what an annuity is and how it works to determine whether it’s worthy of investment.

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What is an annuity and how does it work?

Annuities are contracts between you and an insurance company. You pay them either a lump sum or multiple payments, and in return the insurance company pays out a fixed or variable income stream to the purchaser beginning right away or at some time in the future in exchange for premiums you've paid.

How does an annuity work?

When you buy an annuity, you’ll either send one deposit or regular annuity payments (known as premiums) until you reach the total amount you agreed to invest. The insurance provider uses your funds to grow your money over time and you generally receive tax-deferral earnings and depending on the type of annuity you may receive the benefit of market like returns.

An annuity’s accumulation phase is when you make regular payments and wait as the contract matures. During the accumulation period, your contributions have time to grow, and you can take advantage of tax-deferred growth. The longer you stay in the accumulation period, the more you can earn.  The annuitization period, also known as the annuity payout period, is the time when an annuity owner, or annuitant, receives payments from their annuity. The length and size of the payments, as well as the payout period itself, depends on the type of annuity and its value and there may be extra benefits such as access to emergency medical funds, adjustments for inflation, and death benefit payments to beneficiaries.

6 types of annuities

The structure of an annuity is typically consistent: Deposit money in the annuity, wait, and receive payouts at some set point in the future. That said, there are five distinct kinds of annuities, each with unique implications for your risk profile, payout schedule, and expected returns.

1. Fixed annuities

These contracts are similar to certificates of deposits, except you’re working with an insurance company rather than a bank. In both cases, you lock a set amount of money in the financial instrument and receive a guaranteed interest rate over the set term.

The promise of a guaranteed fixed rate over a fixed annuity’s term may make it appealing to anyone who wants a predictable, passive approach to grow their savings.

2. Variable annuities

When you see variable, think volatility. A variable annuity has the highest risk profile because it generally has zero downside protection. Instead of a guaranteed rate of return, variable annuities give you access to subaccounts, each consisting of assets like stocks, bonds, or mutual funds.

The direct exposure to market prices is a double-edged sword for investors. You stand to gain the most during favorable market conditions. But if your subaccounts performance slides, there’s a chance your annuity dips below your principal investment.

3. Immediate annuities

The fastest way to activate annuitization is to open an immediate annuity. These annuities instantly transform a lump sum of cash into regular payouts. Although growth potential is low, immediate annuities are simple to implement, predictable, and carry low fees.

4. Deferred annuities

If you’re a proactive retirement planner, deferred annuities provide the most time to let compounding earnings work in your favor. These long-duration contracts involve years of accumulation and may allow you flexibility to contribute steady payments rather than one lump sum at the start.

A deferred annuity is also tax-deferred, so you don’t have to pay the IRS for earnings until you start withdrawing.

5. Fixed indexed annuities

Fixed indexed annuities merge the security of fixed annuities with the growth prospects of variable ones. These contracts provide exposure to an index like the S&P 500, this allows your account value to earn interest credits that are linked to the performance of a financial index. If the index goes up, so will the interest credited to your account value. Simliarly if the index you are tracking goes down, you may not earn any interest, but your principal is protected.

To compensate for their protection, fixed indexed annuities often have a max cap on the upside to limit potential gains. So, if the S&P 500 grows 25% in the first year, your account value takes advantage of 20% of growth.

6. Multi-year guaranteed annuity (MYGA)

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A MYGA is a type of fixed annuity that locks in a guaranteed interest rate for a set term, often between three and ten years. Your money grows tax-deferred, and you know exactly what rate you’ll earn for the entire period.

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Pros and cons of annuities

Here are the benefits and drawbacks of annuities so you can decide if they align with your financial goals.

Advantages

• Potential for long-term retirement income: Annuities can reduce the fear of outliving retirement savings. In an annuity contract with a guaranteed lifetime withdrawal benefit (GLWB) rider, you receive regular payouts for life, even if your balance falls to zero.
• Flexibility: There are plenty of ways to make an annuity fit your financial goals and risk preferences. From choosing between investments and fixed interest to combining joint-life options for your spouse, you have the tools to customize an annuity to your needs.
• Tax deferral: Annuitants generally don’t pay a penny in taxes until they withdraw funds. For tax-deferred annuities, throughout the accumulation phase, taxes don’t apply, giving your investments plenty of time to grow penalty-free.

Disadvantages

• Annuity fees: While fee schedules differ, every annuity carries some additional costs. Typically, variable and fixed indexed annuities have the highest fee burdens, but always consider how an annuity’s fees affect your projected earnings. For example, high administrative fees in a variable annuity can reduce your overall returns over time.
• Illiquid asset: Aside from immediate accounts, annuities aren’t as fluid as other investable assets. Once you put funds into an annuity, your money is often locked for years, and early withdrawals come with penalties like surrender charges and market value adjustments.
• Limited growth potential: Most annuity types favor predictability over growth and for fixed annuities you’ll trade potentially higher gains in other asset categories to secure a fixed rate of return.

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What to consider before buying an annuity

If you’re serious about adding an annuity to your retirement strategy, consider the following to ensure you take advantage of their customizability.

• ‍Income needs: Investors usually get involved with annuities to create a guaranteed income stream down the line. So, it’s good to consider your expected living expenses and other sources of income (e.g., social security) to figure out your target annuity payout rate.‍
• Risk profile: Annuities offer flexible investment strategies for your portfolio. Whether it’s participating in market growth or a fixed rate for your entire term — or anything in between — make sure the annuity you buy aligns with your financial goals.‍
• Fees and expenses: Fees, max caps, and commissions limit the total gains in an annuity, so review these rates beforehand and calculate how they impact your investment. Also, even though annuities offer tax-deferred growth, don’t forget to subtract taxes from your withdrawals.

3 strategies to maximize the benefits of annuities

There’s nothing wrong with keeping your annuity as simple as possible, but there are a few techniques to enhance your retirement account’s potential. Consider these strategies when building an annuity income stream:

1. Research annuity riders: Annuity riders aren’t required, but they’re a way to personalize your investment and ensure it meets your preferences. For example, an inflation protection rider adjusts your annuity payments to keep pace with inflation, ensuring your income retains its purchasing power over time. Although these optional protections cost more, their certainty may be more valuable than a 1% annual deduction.
2. Look into laddering annuities: Laddering means distributing your funds across multiple annuities, each with different accumulation and withdrawal periods. This strategy provides more liquidity, as you can access funds from contracts maturing earlier, and allows you to benefit from changes in interest rates over time.
3. Diversify your strategy: Annuities often don't offer the same growth potential as assets like stocks or exchange-traded funds. To balance growth potential with stability, consider spreading your investments across different annuity types (e.g., variable and fixed) or combining annuities with other asset classes to capture potential gains while keeping fixed rates.

Annuity examples

Understanding annuities is easier when you can look at real-world scenarios. Put yourself in each hypothetical annuitant’s shoes and imagine how their plan affects retirement income streams:

• Mark, 50, wants to balance security and growth potential for his retirement years. He purchases a fixed index annuity tied to the S&P 500 with a cap of 6% and principal protection on the downside. Whenever the S&P 500 goes up for the year, Mark gets at max a 6% bump in his contract’s  value. But if it nosedives, he won’t lose his principal.
• Linda just turned 65 and has $200,000 in savings she wants to convert into a steady income stream. After making a lump sum deposit to in an immediate annuity, she starts receiving monthly retirement payments of $1,000, and she’ll continue receiving these payouts for the rest of her life.

By examining these scenarios, you can see how annuities can provide tailored solutions for different financial needs and goals in retirement.