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What is an annuity

If you have annuity questions, you've found the right place for some answers.

a couple learning what is an annuity

A Paycheck for Life

Sometimes referred to as a retirement annuity, a life annuity, or annuity insurance, an annuity is an insurance contract you purchase that guarantees you'll receive a specified amount of money every month for the rest of your life, no matter how long you live. 

One way to think about annuities - they kind of provide the opposite type of protection as life insurance. Most people buy life insurance in case they die too soon, while annuities provide a safety net for living a long life, which many people find very comforting. As we get older, nobody wants to stress at each passing birthday, happy to be alive, but worried about running out of money. An annuity can help ease those concerns.

We hope this article will help you better understand how annuities work and how they might fit into your future plans. To do this, we've enlisted the help of several State Farm® agents, who know first-hand what it takes to help customers feel financially secure as they plan for the retirement of their dreams. 

Keep in mind, the following information pertains to fixed annuities only. Variable annuities work differently and have an investment risk component.

How Do Annuities Work?

At its core, an annuity is a way to receive money in retirement either by saving money over a period of time or by purchasing an annuity with a lump sum. It's a contract between the owner of the annuity and the company issuing it. You buy the annuity, and the company pays you in installments at retirement, including interest that accrues on the money. As Ken Quach, State Farm agent in Houston, Texas, describes them, "An annuity provides a way for you to give yourself a paycheck in retirement, based upon your income needs."

So let's dig a little deeper from there. You can choose to purchase a couple different types of fixed annuities: immediate annuities for when you need income now and deferred annuities for when you need income in the future.

  • Immediate annuities - These are purchased with one lump sum, and you start receiving payments pretty much right away. Most people buy these after they have already retired, to replace the paycheck they received while working.
  • Deferred annuities - Companies offer these as well. If you do not need income today, you can purchase your deferred annuity with a lump sum or periodic payments and choose a time in the future to start receiving payments. These may be purchased before retirement. 

Quach says that most people who purchase deferred annuities tend to be more risk-averse. "They want a low-risk savings vehicle prior to retirement that will be there for them no matter what. Most people who buy immediate annuities are close to, or are already retired, and looking for a way to create a steady income stream right away."

Deferred annuities have two phases:

  • Accumulation Phase - when you're putting the money in
    Quach explains, "With deferred annuities, the accumulation phase is the period of time after you purchase your annuity and before you start receiving payments. During this phase, your investment will grow tax deferred at a guaranteed minimum interest rate.' 
  • Annuitization Phase - when you start taking the money out
    The annuitization phase is when you start receiving payments, typically at retirement, and you may have a variety of payment options.

Payout Options 

Immediate and deferred annuities have a number of annuity payout options you can select from, and if you're worried you might die too soon, some options will allow your family to get back what you put into it. 

As Patrick Blevins, State Farm agent in Waynesboro, Virginia, explains, "A big misconception is that if I give State Farm, say, $100,000, and I pass away after a couple of payments, State Farm keeps my money. That's not the case with some payout options.

"People who purchase annuities have a number of choices for their payout period, and one option may be the cash refund option. With this option, your beneficiary will receive a lump sum payment based on whatever portion of the initial amount that wasn't paid out to you, so it guarantees the return of principal. On the flip side, if you're still living once your initial investment has been paid out to you, you'll still continue to receive the same monthly payment for however long you live. 

"Life income annuities with period certain options are popular too, where if you pass away before the period certain, your beneficiary is guaranteed to receive payments for the number of years you chose. If you live past that date, you'll still continue to receive payments for the rest of your life."

Quach recommends sitting down with someone to talk through your options. "With so many payment choices, it's best to talk to an agent about what's right for you."

What Is a Retirement Annuity?

Some people refer to annuities as "retirement annuities" because they're commonly used as part of an overall retirement plan. Knowing how much money you'll need in retirement can be a tricky question since we don't know how long we're going to live or what kind of health conditions we may or may not experience. So an annuity can provide a way to supplement your Social Security and other retirement savings.

Blevins emphasizes the retirement aspect when he explains annuities. "An annuity is like having a paycheck in retirement, that you'll continue to receive no matter how long you live." 

Income vs. an Allowance

Blevins sees customers use annuities in different ways. "Some people use annuity payments to help cover their fixed expenses that Social Security doesn't cover. For them, it's income to help continue in a comfortable lifestyle. Others have their fixed expenses covered already and use annuity payments as an allowance. They use them to travel or pursue hobbies or spoil their grandkids. 

"It can also prevent people from overspending. When you're retired, every day can feel like a Saturday, and most of us spend more money on the weekends. So putting some of your money into an annuity, instead of having it all readily available, can offset the risk of spending."

Basic vs. Discretionary

Sammy Yim, State Farm agent in Burlingame, California, sees a lot of people using an annuity to help with their basic expenses, so he helps them figure out how much they'll need to feel comfortable. "When I meet with customers to help decide how much to spend on their annuity, we look at what their basic and discretionary expenses will be in retirement. Basic (fixed expenses) are costs they know they'll have every month, like rent, utilities, and food. Discretionary (variable) expenses are the fun things - traveling, golfing, supporting a crafting addiction. 

"An annuity can help make sure their basic expenses are covered if Social Security and pension payments (if one is so lucky) aren't going to cut it. It's a safety net so that no matter what, their bills are paid. Then they can invest some of their retirement savings more comfortably in other things, knowing their basic expenses are taken care of."

What Is a Life Annuity?

Annuities are also often referred to as "life annuities" because they provide you with a guaranteed income for life. As Blevins explains, "A major concern people have about retirement is running out of money. An annuity from State Farm can ensure that you will never outlive your money in retirement.'

What Is Annuity Insurance?

"Annuity insurance" is another way annuities are described, and that's really the basis of what an annuity is. Yim explains them as "very simple insurance contracts. Their main purpose is to protect you from outliving your income." 

Why Buy an Annuity?

Denise Elliott, State Farm agent in Durango, Colorado, provides a good example of how it can fit into a bigger plan. "One of my customers goes to Ireland every year and it costs him about $10,000. He doesn't like taking money out of the stock market for that, so he purchased a deferred annuity. Every year, he uses money from his annuity for his trip.' 

Quach recommends them for people who don't like to take a lot of market risk, "It's great for people who are not very risk tolerant, who want a safe place for their money to grow, with some form of guarantee they won't outlive their money in retirement."

Quach also talks about the tax benefits of an annuity, "The money that's sitting in your annuity grows tax-deferred, so that is one of the biggest benefits for a lot of my customers."   

Blevins stresses the role annuities can play in some people's lives, "I think annuities play a critical role in a complete financial plan, especially for folks that have accumulated monies and are retiring or are already retired. We need to have conversations with people about what they do. When customers do understand how annuities can be a puzzle piece to their overall plan, they are happy with them."

"It's a safe place with a reasonable rate of return. It's a nice stream of money you get for the rest of your life."

Get Started Today 

If you're interested in learning more about an annuity and how it could fit into your future goals, State Farm agents are ready to help talk you through options that would make the most sense for your own life.

Neither State Farm® nor its agents provide tax or legal advice.

Please consult your tax, legal, or investment advisor regarding your specific circumstances.

Federal income tax-deferral is provided by the tax-qualified retirement plan. No additional tax-deferral is provided by an annuity.


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