Annuities are investment products designed to offer the owner a steady income stream in the future. Some people buy an annuity when they receive a lump-sum payment from a legal settlement, an inheritance or an employer. Some annuities qualify as tax-deferred retirement accounts. Others are structured to provide a stream of income earlier in life and do not offer tax advantages.

Annuities are different from life insurance, even though they are sold by life insurers. Life insurance helps support a beneficiary upon the death of the policy owner. Annuities are meant to benefit the policy owner until their death.

The owner of an annuity cannot outlive the income stream outlined at purchase. In other words, if you are promised a set amount of cash at regular intervals beginning at a certain start date, that income will continue unabated until your death. Once you die, payments cease unless you have made special provisions with the insurer that sold you the annuity. We’ll talk about those provisions, called riders, later in this piece.

How an annuity works

An annuity is purchased with an initial lump sum that is invested for future payments back to the owner. There are three primary types of annuities: fixed, variable and indexed.

Just as its name implies, a fixed annuity provides a fixed minimum cash payment at agreed-upon intervals in the future, regardless of investment performance. If the market outperforms projected expectations, you will not benefit. However, if the market underperforms, you will sidestep losses and still receive the income originally promised. Often, you can add to a fixed annuity to increase your payouts.

This reliability makes fixed-income annuities a particularly attractive option for individuals who have other retirement income linked to market conditions, such as a 401(k). With the guaranteed income from a fixed annuity, it may be easier to leave other vulnerable investments in place until the market recovers.

A variable annuity provides payments based on investment performance. While this makes a variable annuity riskier, the potential for higher payouts may make this a more attractive option for some people. Note that you will pay higher administrative fees for a variable annuity than you would for a fixed.

An indexed annuity is similar to a variable annuity, except that its growth is based on a chosen index from the stock market — for example, the Dow Jones or the S&P 500. You don’t choose the stocks or investments the annuity is tied to; your insurer does, and you know ahead of time which index will be used. If the index underperforms, however, your annuity could fall in value.

In addition to choosing your annuity type, you will be asked to make some other decisions about timing and benefits.

Regarding timing, you may choose immediate payment or deferred payment.

An immediate payment will result in regular cash disbursements starting right after the lump sum is deposited. This may be an appropriate way to manage a large cash settlement or inheritance so you have timely access to your money while still safeguarding long-term income. Know, however, that you won’t be able to get your money back once you start taking distributions and your beneficiaries often won’t receive much back (or any, in some cases) if you die early on in the distribution phase.

Deferred payment means disbursements will be delayed until a specified future date. Deferred payments are the standard choice of individuals planning for retirement. We will talk below about protecting this investment in the case of an early death.

If you are using an annuity as a retirement investment, you will generally have to wait until the age specified by the IRS (currently 59½) to receive payments without a withdrawal penalty. However, there are some exceptions for the disability or death of the annuitant and, under some contracts, for long-term care costs. The insurer that sold you the annuity could also assess a surrender fee if you haven’t reached the specified date at which you agreed to withdraw funds.

You may hear the terms “accumulation phase” and “annuity phase” discussed when considering the timing of your annuity. The accumulation phase is the time between the initial investment and the start of payouts. The annuitization phase begins when you start receiving payouts.

Your insurer may offer a rider, which is an addendum to your annuity contract, that guarantees or improves your benefits in some way. For example, a death benefit rider may allow your beneficiary to collect a portion of your annuity if you die before the annuitization phase begins — or even collect payments for a period of time after you die. Your contract will specify the amount and timing of the payout, and there is a charge for such a rider. Another example is a cost-of-living rider that adjusts future payout amounts based on the rate of inflation. We’ll talk about long-term care riders in the next section.

For variable annuities, there are riders that protect your initial capital investment, which is important because if the stock market tanks, you could lose not only any investment earnings but also the money you laid down to buy the annuity. You may also be able to get a death benefit rider for a variable annuity that protects your beneficiary from market-caused loss of your principal.

Ask your agent about riders. Some offer excellent protection for your investment should you die early or become disabled.

Part of your investment portfolio

Many retirement funds are tied to stock investments and are exceedingly vulnerable to market volatility. Fixed annuities help protect your financial status during periods of market instability or declines. But it is pretty expensive to start an annuity. Your insurance professional will help you evaluate your financial assets to see how you can best use the money you have available.

For example, you might want to roll over some of the money you have in an IRA or 401(k) when the market is strong and your fund’s value is high. If you get a retention bonus or an early-out bonus, you might use that to start an annuity. The goal is to spread your retirement savings across market-exposed and guaranteed funds.

Long-term care costs are another financial burden an annuity can help you bear. Many insurers now offer fixed annuities with long-term care benefits. They are usually very expensive, but they offer distinct advantages over long-term care insurance. For example, you won’t pay premiums to an insurer as you would with a standard long-term care policy, money that is gone if you never make a claim. Instead, you’ll make a single, lump-sum investment in the annuity/long-term care hybrid, which either pays for long-term care or pays the agreed-upon regular income stream.

As you can see, there are many ways to tweak an annuity so it best fits your full financial plan. Annuities require a fairly large lump-sum investment, so they are not for everyone. They also lock up your initial capital and charge substantial fees for removing or rolling the funds over. That said, they can be an excellent complement to other retirement accounts that vary with the performance of the stock market, so talk to your insurance agent about the options available to you.