What are annuities and how do they work?

Annuities are a financial product commonly associated with retirement planning due to their ability to provide reliable payments over time. But lately, thanks in large part to their potentially higher yields and tax advantages, annuities are starting to gain more widespread popularity — even among younger investors.

In particular, fixed-rate deferred annuities — "which resemble certificates of deposit, but offer higher yields on average thanks to the broad portfolio of investments insurance companies hold" — are "booming," said The Wall Street Journal, probably due to "the Federal Reserve's rate increases beginning in 2022." But even as the Fed has started to cut rates, "sales show little sign of slowing," the outlet added.

Before you consider hopping onboard this new trend, it is important to understand exactly how annuities, a notoriously complex financial vehicle, actually work.

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What is an annuity?

"An annuity is a contract with an insurance company that provides a stream of income, typically in retirement, in exchange for money paid into the annuity," said Bankrate. To buy an annuity, you either pay a lump sum or make a series of payments over time, and in return, you will receive payments, either all at once or at regular intervals.

These payments can begin immediately, but in general they are "deferred — meaning you have to leave the money untouched for a number of years or face stiff penalties," said CNBC Select. The amount of the payments you receive typically depends on how much you pay in.

How do different types of annuities work?

The specifics of how an annuity works depends on the type of annuity it is. Here is an overview of some of the main types:

Immediate annuities: As the name suggests, an immediate annuity "starts providing income payouts right after you make your initial lump sum investment," said CBS News.

Deferred annuities: A deferred annuity "is designed to grow on a tax-deferred basis, providing guaranteed income to the annuitant starting on a particular date they choose," said Kiplinger.

Fixed annuities: With a fixed annuity, an "insurance company promises you a set rate of interest that is locked in rather than being tied to market rates," said Credit Karma. A fixed annuity can be immediate or deferred.

Variable annuities: Variable annuities "allow the owner to receive larger future payments if investments held in the annuity fund do well or smaller payments if its investments do poorly," said Investopedia.

Indexed annuities: An indexed annuity "offers a rate of return that tracks an index such as the S&P 500," said Bankrate.

What are the pros and cons of annuities?

Annuities can offer definite benefits, depending on the type you purchase. These include:

Reliable stream of income. "With most types of annuities, especially fixed annuities, you are guaranteed to receive a specified income payment amount on a regular schedule," said CBS News. Some annuities can even offer payouts "for as long as you live."

Tax advantages. "Qualified annuities offer tax-deferred growth on your investment until you withdraw the money or begin receiving payments," said Bankrate, which is helpful when saving for retirement.

No contribution or other limits. "Unlike an IRA or 401(k), an annuity doesn’t require annual contribution limits," said Kiplinger, plus there is "no limit on the amount of annuities you can have."

On the other hand, it is important to weigh the following drawbacks of annuities as well:

Complexity. Annuities are not a straightforward financial product, with contracts "often totalling dozens of pages" and varying "markedly from one to the next," said Bankrate.

Fees and commissions. It is possible that annuities can have "fees, such as surrender charges, mortality and expense risk fees, sales and commissions and administration fees," said Kiplinger, which eat into your returns.

Lack of liquidity. Though you will "receive your income stream, and may be able to withdraw some of the principal," said Bankrate, "for the most part, your money is locked into the annuity and you have relatively little access to it."

Possible caps on returns. While "your annuity may be guaranteed not to lose money," it is possible that "providers put a cap on the interest rate you can earn," said CNBC Select.