What Is An Annuity?

Annuities are contracts with insurance companies. You give the insurance company money now. The insurance company returns your investment and the interest earned on it (less expenses), at a later time. The insurance company makes payments. Those payments can be for life, or for a fixed number of years, depending on the option you choose.

Put another way, an annuity is a bet you make with an insurance company. You are assuming you will live long enough to collect more in monthly payments than you paid for the policy. The insurance company assumes you (or enough people in their annuity pool of business) will not.

The insurance company takes into consideration your age, gender and the purchase amount in determining the amount of income stream it will provide. As you compare annuities, you need to keep in mind the different types of annuities and different rates.

Fixed annuities are considered insurance products, not investments. The term annuity comes from the Latin word "annua" which can loosely be translated to mean annual stipend. The stipend, or what is more modernly referred to as the income stream, can be for a defined time period (for example, 20 years), or for life.

In most cases, an annuity purchase is an irrevocable decision. You cannot change your mind and cancel an annuity contract once you begin to receive income (without paying significant penalties).

Key annuity characteristics include:

  • Parties. Annuities can cover a single person, or more than one person. The insurance company is the other party in the contract.
  • Payment. The way in which you enter into an annuity contract is by making a Purchase Payment. Your Purchase Payment may be made in a lump sum, or through regular and periodic payments. The payment duration is specified in the contract.
  • Growth Phase. This is sometimes called the accumulation phase. It is the time in which the funds are invested by the insurer, and grow tax-free. The growth phase usually lasts for a period of years but could, in the case of a single-payment annuity, be very short. The opportunity to withdraw funds during the accumulation period is limited. Beyond this point, withdrawals are subject to penalties by the Internal Revenue Service (IRS) and the insurance company. Withdrawals made prior to attaining the age of 59 1/2 will result in a 10% penalty imposed by the IRS, in addition to normal taxes. Withdrawals made before the end of the accumulation period are subject to surrender charges by the insurance company as well.
  • Distribution Phase. This is when the insurer returns the invested proceeds in the form of regular payments. The payments are divided into two categories: return of principal, and investment growth. You are only taxed on the interest growth, not on the return of principal. Ordinary income tax rates apply.
What is an Annuity

Common Uses for Annuities

Annuities play an integral role in many retirement plans. If someone wants to have an income stream once they are no longer earning a salary, an annuity may be an attractive investment. An annuity provides tax deferred growth of savings and can be an assurance of lifelong income.

Retirement planning is not the only use for annuities. Annuities are relatively common in legal verdicts and settlements. Damage awards, particularly in personal injury cases, are often intended to compensate for lost income extending years into the future. Annuities are uniquely suited for this purpose because they can provide regular, consistent payments lasting for the life of the recipients.

There is an enormous array of annuities available in the market. Different features and benefits are intended to address specific consumer needs. While there are many variations, there are only two main types, fixed or variable.

Fixed annuities offer guaranteed income. Two key variables are set with a fixed annuity: income rate and time period. You can buy a fixed annuity that pays income for life. Another alternative is to have income paid to you over your lifetime plus your spouse's lifetime. This is called a joint life with last survivor annuity.

With a fixed annuity, you could also choose the time period to receive the payouts, for example, ten or twenty years.

Fixed annuities create a reliable income stream for life that many retirees find appealing. A lifetime annuity will continue to pay out, no matter how long you live. Keep in mind, however; the guarantee of a lifetime income is only as reliable as the solvency of insurance company. The long-term nature of the promise calls the financial strength and stability of the insurer in question. You want to be sure the insurer will be around to keep its commitment to you.

The other type of annuity is a variable annuity. Variable annuities involve more risk than fixed annuities, but have the potential for higher return.

Variable annuities too can offer the opportunity for lifetime income. Unlike fixed annuities that provide a guaranteed return, the payments from a variable annuity will fluctuate. Here is why. The insurance company invests your funds in portfolios similar to mutual funds. The amount of income you receive from a variable annuity fluctuates with each payment depending on the performance of the portfolios you choose.

Annuity Rates - Pros and Cons

Annuities offer considerable advantages over other types of retirement products, especially if you (like many Americans) fear outliving your means. As you compare annuities, remember they have advantages and potential disadvantages that should be carefully considered.

Advantages:

  • Tax Efficiency: Annuities are tax-advantaged retirement savings tools. Your annuity investment growth is only taxed when you receive payments. It is called a tax deferred savings opportunity because your tax obligation is delayed until a later time when, most likely, you will be at a lower tax rate. The tax paid at distribution is at an ordinary income rate. This makes annuities more appealing than CDs, money market funds, or other conservative investments.
  • Safety of Capital: The money you invest in an annuity is relatively safe. Insurance companies, which are required to keep cash reserves in place issue annuities. The purpose of the cash reserve is to ensure that if the insurance company were to encounter fiscal difficulties, it could still pay obligations to existing policyholders. Most states require insurers keep reserves of up to $100,000 for each annuity. One caveat, however, is that a payment guarantee is only as reliable as the solvency of the insurance company. You should research the strength and stability of the company and determine its rating with the leading independent rating services. Insurers rated highly by the rating agencies are considered more financially secure.
  • Liquidity: The money you put in an annuity is accessible, at a cost. Most contracts will allow you to withdraw a minimal amount each year (between 10-15% of the account value) before incurring surrender charges. It is important to understand the withdrawal clause before entering into the contract. Withdrawals exceeding the allowed amounts can be costly.
  • Rate of Return: Annuities may offer higher rates of return than other safe investments. Annuity rates of return offer stability, which is particularly valuable during times of great market fluctuation.
  • Annuity Pros and Cons
  • Income stream: Fixed annuities provide reliable income to people who often have no other means of income. An annuity puts you in control of when you will receive your income payments (e.g., monthly), and for how long. You can decide to get payments for a fixed period of time, like twenty years, or if you think you are going to live longer than that, you can chose to receive payments for the rest of your life.
  • Inflation Protection: Inflation can have a devastating effect on wealth. If you are concerned about the impact of inflation, you could use an annuity to ensure your monthly income keeps pace with increases in the cost of living. This is an add-on feature offered by many insurance companies. It typically increases the cost of the annuity. If purchased, the annuity will either cost you more in purchase payments, or you will receive less income in the beginning.
  • Avoid Probate: Because annuities are life insurance contracts, probate can be avoided when beneficiaries are declared.
  • Unlimited Contributions: Unlike other tax-advantaged savings vehicles found in many retirement plans, you are not constrained by funding limits. You can put as much into an annuity as you wish.

Disadvantages:

  • Fees: Annuities can be expensive. Sometimes the fees can cancel out the tax benefits. Some annuity fees, like set up and administrative charges, are straightforward. Others are sometimes difficult to detect. Not all annuities are alike. There is significant variation in fees charged. There are good annuities with low fees in the market; you just have to look for them.
  • Short Term Money: If there is a chance you will need your money returned in the short-term (one to two years) an annuity is unsuitable for you. Annuities are best for people who do not need the income stream for at least five years and will have reached the age of 59 ½.
  • Surrender Schedule: Annuity contracts impose surrender charges if you withdraw money before the contract matures. Some surrender schedules require a waiting period as long as ten years before you can surrender without penalty.
  • Lower Investment Returns: There is a lost opportunity cost involved in investing in annuities. The trade-off for guaranteed income is that you will be sidelining that money. You will not be able to invest it in the stock market, and potentially make more investment gains over the same time period.
    Commissions: The insurance agent that you purchase an annuity from receives a sales commission. The commission is typically based on the overall purchase price of the annuity. If your contract includes add-ons, the sales agent’s commission raises. An unethical sales agent may prompt you to purchase a product or additive features that are not in your best interest. Commissions are not always paid directly. Sometimes commissions are recouped annually in the form of higher fees.
  • When you compare annuities, you can ensure that you are getting the best product for you.
Annuity Directory
Annuity Directory

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