Unpacking Annuities

Key Takeaways

Many people understand the basic role of life insurance: To protect loved ones financially if you die earlier than expected. Annuities are also contracts issued by life insurance companies, but they are designed to address different needs – providing income if retirement lasts longer than anticipated, protecting savings from market declines and introducing more stable outcomes over time, even as interest rates change.

In simple terms, annuities shift financial uncertainty away from the individual and onto the insurer, and in exchange, owners accept tradeoffs related to liquidity, flexibility and cost. Before deciding whether an annuity belongs in a financial plan, it helps to understand how it works, along with its benefits and limitations.

How Annuities Are Structured

An annuity is issued by an insurance company and involves three primary roles:

• The owner, who funds the annuity and controls key decisions, such as when income begins and who the beneficiary is.
• The annuitant, whose life expectancy is used to determine the size and duration of income payments. In most cases, the owner and annuitant are the same person.
• The beneficiary, who may receive remaining value if the annuitant dies, depending on the contract terms.

Once these roles are defined, most annuities follow a similar framework. They include two phases: An accumulation period, when assets are contributed and grow over time, and a payout period, when income is distributed based on the choices made in the contract.

The Accumulation Period

The accumulation period is when the owner funds the annuity before income begins. This phase can be brief or extended, depending on the annuity type.

• Immediate annuities typically involve a lump-sum payment that is quickly converted into income.
• Deferred annuities allow contributions to grow over time before payouts begin.

During this phase, growth is generally tax-deferred, meaning taxes are owed only when funds are withdrawn. How an annuity grows depends on its design: Some earn a fixed rate set by the insurer, others track a market index, while some rise or fall based on how their investments perform.

Access to funds during the accumulation period is often limited. Many annuities include a surrender period – sometimes lasting several years – during which withdrawals may trigger fees or tax penalties. For this reason, annuities are generally better suited for assets that are not needed for near-term expenses.

Importantly, the transition from accumulation to payout is often flexible and can be adjusted as income needs change.

The Payout Period

The payout period begins when the annuity starts distributing income to the annuitant. The payment structure will depend on contract choices and any optional add‑on features (“riders”) selected.

Key decisions typically include:

• When payments begin. Income may start soon after purchase or be deferred to a later date.
• How long payments last. Options can include a set number of years or payments for the annuitant’s lifetime.
• Who receives payments. Some annuities extend income to a spouse or include beneficiary features.
• How payments are calculated. Fixed annuities provide a known payment amount, while variable annuities base payments on investment performance.

These choices affect income stability, flexibility and the potential value received over time.

Risks and Benefits

Annuities offer features that may be appealing in retirement planning, but they also carry meaningful risks and tradeoffs, including:

• Withdrawal limits. Withdrawals during surrender periods may result in fees and penalties, though many contracts allow partial withdrawals (often up to 10% annually) without those charges.
• Complexity and cost. Riders, guarantees and underlying investments can increase expenses.
• Insurer risk. Annuities are backed by the issuing insurance company, not FDIC insurance. As such, any guarantees are generally limited to the claims-paying ability of the insurer.
• Market-related uncertainty. Variable and indexed annuities may deliver lower returns during weak markets, and performance may be capped when the targeted index or benchmark achieves or exceeds a specific percentage increase.
• Reduced flexibility. Once income begins, changes to payments or access to principal may be limited.

At the same time, one of the primary benefits of certain annuities is the ability to create a predictable income stream that does not depend on market performance or lifespan. This can make it easier to decide how much to spend and when. Additional potential benefits include:

• Customization. Contract options can align income with personal and family needs.
• Tax-deferred growth. Earnings are not taxed until withdrawn.
• Beneficiary designation. Some annuities allow assets to pass outside probate.
• Optional liquidity features. Certain contracts permit limited withdrawals without surrender charges.

The usefulness of an annuity depends on how its features align with an investor’s goals, time horizon and other sources of income.

Annuities can be useful tools for addressing several retirement challenges, from generating income if retirement lasts longer than expected to helping manage market declines and changing interest rates. Because they vary significantly in structure, cost and risk, they may not be appropriate for some investors and merit careful review. A Baird Financial Advisor can help evaluate whether an annuity aligns with your goals, other assets and income needs, and if so, which structure may be appropriate.

This information has been developed by a member of Baird Wealth Solutions Group, a team of wealth management specialists who provide support to Baird Financial Advisor teams. The information offered is provided to you for informational purposes only. Robert W. Baird & Co. Incorporated is not a legal or tax services provider and you are strongly encouraged to seek the advice of the appropriate professional advisors before taking any action. The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.

Annuities carry unique risks including market risk, investment risk and claims-paying abilities of the insurer. There may also be instances where a contract will pay out less than the premiums paid or expire within the lifetime of the insured. There may be penalties for early withdrawal, and they are not insured by the FDIC because they are insurance, not an investment.