How Do Annuities Work?

One of the biggest fears people have about retirement is outliving their savings. On average, 45 percent of Americans believe they will outlive their savings, according to a 2023 study by Northwestern Mutual. However, there is a way to plan financially for this so-called “longevity risk”: an annuity. This unique financial product can provide guaranteed income for the rest of your life. Here’s how annuities work.

How do annuities work?

An annuity is basically a contract between you and an insurance company that can help guarantee some income in retirement. Annuities come in two basic versions: accumulation (sometimes referred to as deferred annuities) and income annuities.

Whether you’re in retirement or still saving for retirement, an annuity may take a little risk out of your long-term financial plan because it generally comes with some guarantees that you won’t get with market investments.

An annuity can be purchased with either pre-tax or after-tax dollars. A qualified annuity is purchased with pre-tax dollars using a retirement account such as an IRA, 401(k) rollover or 403(b) rollover. The money is not taxed until it is paid out. A non-qualified annuity is purchased with money that has already been taxed. If this type of annuity grows tax-deferred and is used to create lifetime income, the tax is spread out over your life expectancy.

Deferred annuities

There are three types of deferred annuities: fixed, variable and indexed.

A fixed annuity will accumulate value based on a fixed interest rate. So, when you purchase your annuity, you’ll know how much money it will accumulate and what your payments will be in the future.

With a deferred variable annuity¹, your premium payment is invested in one or more subaccounts, which are investment funds for you to choose from. The annuity value is determined by the performance of those subaccounts in the market. The performance of the subaccounts is not guaranteed and can fluctuate, so there is a risk that you may lose money. (Any contractual guarantees are backed by the claims-paying issuer.) Considering all this, deferred variable annuities are more appropriate for someone who is willing to accept a higher risk in exchange for potentially higher returns and who has a long time horizon.

An indexed annuity has features similar to a variable annuity. Rather than choosing investments, your returns are pegged to an equity-based index, such as the S&P 500. However, how that index is tracked depends on the methods used by the insurance company. Also, different companies may cap the amount of interest you can earn in an indexed annuity or put in a floor to limit potential losses.

How deferred annuities work

Deferred annuities start in an accumulation phase, or the “growth phase.” This is the time when you’re putting money in and letting it grow on a tax-deferred basis. Earnings are reinvested and added to the principal, so over time, your money has a lot of potential to grow, thanks to compounding interest.

Typically, deferred annuities begin with a “surrender period.” An insurance company would charge a penalty if you take your money out within the first few years. The length of the surrender period will be specified in your contract, and eight years is common. In addition, making cash withdrawals prior to age 59½ may result in a 10 percent IRS penalty for an “early withdrawal.”

Then, when you get to the annuitization phase—it’s pay day! Your financial planning pays off when you begin to receive a stream of income (or a lump-sum payment). In some cases, your spouse or a loved one could receive your payments if you die earlier than expected.

Who might benefit from a deferred annuity?

The earlier you buy a deferred income annuity, the more potential there is to increase your payout amount down the road. So, a deferred annuity might be a good fit for younger savers who are maxing out their contributions to other retirement accounts and want to continue building and growing their tax-deferred nest egg.

Other points to consider

For all annuities, distribution of gains will be subject to ordinary income tax. You’ll also want to pay attention to fee structures (like surrender charges). Remember that in most cases you’ll be charged a 10 percent penalty if you withdraw money from your annuity before reaching age 59½.

Because there are so many nuances to it, you’ll really want to make sure you understand how an annuity works before buying it. This is where a financial advisor can be really helpful. A Northwestern Mutual financial advisor can break down the different types of annuities and help show you how annuities can work with other parts of your retirement plan to best support your needs in retirement.

Income annuities²

An income annuity is designed to pay out a guaranteed income. There are immediate income annuities that provide an income stream typically starting within 12 months, and there are deferred income annuities for which the start date of the income stream is delayed, or “deferred,” up to several decades.

How an income annuity works

Income annuities are typically purchased with a lump-sum payment; however, some income annuities also allow for additional premium deposits.

The income annuity will then make regular payments back to you for the rest of your life beginning at a set date. The amount of your payments will depend on factors like how much you paid in, how long you’re expected to live, and what features and guarantees you want to add to your annuity.

Who might benefit from an income annuity?

An income annuity is usually a good fit for risk-averse retirees or people very close to retirement who want to convert a lump sum of cash into a guaranteed stream of income. This income stream will last either for the rest of their lives or for a specified time frame.

If you’re in retirement, saving and compounding growth likely take a backseat to a focus on generating reliable, predictable income. Instead, you may be focused on avoiding outliving your savings, which an income annuity can help with.

Other points to consider

One of the biggest concerns people have when buying an annuity is that the insurance company will keep all their money if they die right away. But here’s the good news: Many annuities have safeguards you can take advantage of to prevent this from happening. Depending on the annuity, you may be able to name a beneficiary so that a loved one can continue to receive payments—getting back at least what you put into the annuity—should you die earlier than expected.

Many income annuities offer a feature called a “period certain,” which guarantees that a certain number of payments will be made to you or your beneficiaries even if you die early. Some annuities offer a “cash refund” option, which guarantees that a lump sum will be paid out to your beneficiaries when you pass away if you have received less in income than you paid for the annuity.

How to get money out of an annuity

There are many options for how you’ll receive income from an annuity, but ultimately, how you get paid will depend on the annuity product you purchase.

• If you choose a life option, you get income until you die. It’s a popular way to guard against the risk of outliving your retirement income.
• Some couples choose a joint-life or joint and survivor payment option so that payments (either in the full amount or a reduced amount) will continue for whichever spouse (or other joint annuitant) lives longer.
• A period certain option pays you (or your beneficiary if you pass away during the period) during a certain time period.
• A lump-sum option returns your money (and any growth) to you in one payment. Because all the money is coming to you at once, there’s typically less opportunity for growth, so the payment can be less than with other annuity options.

Final considerations about annuities

Depending on where you are in your retirement saving plan, an annuity may or may not make sense for you right now. As you weigh whether an annuity fits in your plan, it’s important to work with a financial advisor to understand the pros and cons of an annuity and how an annuity might can complement other retirement savings.

You should also consider the financial strength of the company you purchase the annuity from. An annuity is only as good as the company’s ability to guarantee its financial commitment to you, so you’ll want to buy an annuity from a company that has an excellent financial strength rating and will be around for many more years.

Ultimately, deciding whether to buy an annuity is a personal decision that depends on your individual financial situation. A Northwestern Mutual financial advisor can take a look at all of your retirement assets and help you decide whether an annuity fits in your strategy.

1. Variable annuities have additional charges associated with them that should be made clear: Variable annuities are subject to fees and charges, such as mortality and expense charge, annual contract fee, sales load versus surrender charges, and portfolio expense fees associated with the underlying investment options. Please refer to the Prospectus for details of all fees and charges.

2. Income annuities have no cash value. Once issued, this annuity cannot be terminated (surrendered), and the premium paid for the annuity is not refundable and cannot be withdrawn.

No investment strategy can guarantee a profit or protect against a loss. All investments carry some level of risk including the potential loss of all money invested.

Guarantees backed solely by the claims-paying ability of the insurer.

3. Northwestern Mutual continues to have the highest financial strength ratings awarded to any U.S. life insurer by all four of the major rating agencies: A.M. Best Company, A++ (highest), 8/23; Fitch Ratings, AAA (highest), 8/23; Moody's Investors Service, Aaa (highest), 6/23; S&P Global Ratings, AA+ (second highest), 5/23. Third-party ratings are subject to change. Ratings are for The Northwestern Mutual Life Insurance Company and Northwestern Long Term Care Insurance Company.