Annuity

With an annuity, an individual makes a contract with an insurance company or other financial institution specifying that in exchange for the annuity buyer, or annuitant, purchasing an annuity, the seller will pay a lump sum of money immediately or will make periodic payments for a designated period at some time in the future. The designated period may be for a specific number of years or for the remainder of the annuitant’s life.

Most annuities are created to provide a steady flow of cash during an individual’s retirement years. Some annuities are designed to provide regular payments to an individual who has received a large sum of money, such as from a legal settlement, inheritance, or by winning the lottery.

The three main types of annuities are fixed annuity, variable annuity, and indexed annuity. Each has benefits and risks. A fixed annuity provides a guaranteed income stream, while a variable annuity typically offers the highest returns but provides no guarantee; in fact, the entire investment can be lost. An indexed annuity has characteristics of both a fixed annuity and a variable annuity.

Background

The process of purchasing an annuity is relatively simple. An individual purchases an annuity from a financial institution, such as an insurance company, brokerage firm, or mutual fund company. The individual can purchase an annuity with one payment or an initial payment and monthly premiums. The financial institution invests the money, deducts fees for expenses and commissions, and pays the annuitant a lump sum or monthly payments at some point in the future.

An immediate annuity turns the purchase price of the annuity into a steady stream of retirement income. The buyer makes one payment and the insurance company immediately begins making monthly payments that last until the annuitant’s death or a set time. The amount of the monthly payments is fixed based on the purchase price, projected earnings based on a minimum interest rate, and the annuitant’s current age and life expectancy. Immediate annuities are fixed annuities.

A deferred annuity is a savings and investment tool that provides retirement income at some time in the future. The buyer makes an initial payment and typically has the option to make additional contributions through regular premiums. The money is invested, usually in mutual funds or stocks. The annuitant selects the investment options. A deferred annuity can be a fixed annuity, variable annuity, or indexed annuity.

Every deferred annuity has two phases. The first phase is the accumulation phase. This includes the initial investment, any contributions or premiums added to the annuity, and earnings on investments. The annuitization phase, also called the payout phase, is the period when payments are made to the annuitant. Payments may be for a lump sum, a fixed period such as ten years, or the remainder of the annuitant’s life. The payment amount is determined in part by the type of annuity. For example, a fixed annuity will pay a guaranteed fixed monthly amount determined at the time of purchase, while the monthly payment for a variable annuity is based on the value of the earnings as well as other factors, such as the annuitant’s age and life expectancy.

All money put into an annuity is tax deferred, as are the investment earnings of money in an annuity. When money is withdrawn, the gains are taxed based on the annuitant’s income level at the time of withdrawal.

Many annuities have features that can be purchased for an additional cost. These include death benefits that pay a beneficiary if an annuitant dies before receiving a payment, accelerated payments if an annuitant becomes terminally ill or confined to a nursing home before payments commence, and cost-of-living riders that provide an adjustment for inflation.

Although the purchase process is simple, annuities have different structures and complex terms. A prospective buyer should read the prospectus carefully and consult with a financial advisor or tax consultant to understand the terms and any tax implications.

Overview of Annuities

A fixed annuity provides a fixed rate of return and a fixed payout. There are two types of fixed annuities. A life annuity pays a fixed amount every period, such as monthly, until the annuitant dies. A term-certain annuity pays a fixed amount every period for a specified amount of time.

While a fixed annuity has very low risk, it also has very low growth opportunity. The insurer assumes all the risk of investments and pays the annuitant only a guaranteed rate of interest on the money in the annuity. Although it is a fixed annuity, the interest rate is not fixed. It may fluctuate to match the interest rate in the market. The insurer, however, guarantees a minimum interest rate. The insurer continues to pay the guaranteed interest rate even if national interest rates fall, and the insurer, not the annuitant, bears the loss.

A variable annuity is an investment product. The seller, such as an insurance company, invests the money put into an annuity in subaccounts made up of investments similar to mutual funds, stocks, and bonds. The annuitant can select the investment options based on the desired growth and risk. The performance of the investment options determines the payout amount. A variable annuity provides the greatest opportunity for growth and return on investment, but it also has the highest risk. There is no guarantee the investments will do well. If they do poorly, there is the risk of loss with low or no payout. A variable annuity is a security and is regulated by the US Securities and Exchange Commission.

An indexed annuity, also known as an equity-indexed annuity, combines features of a fixed annuity and a variable annuity. It is like a fixed annuity in that it guarantees a certain rate of return, which is tied to a stock index rather than interest rates. It also guarantees a minimum payout amount based on the annuity’s value. Like a variable annuity, it allows for some growth opportunities. These growth opportunities have limitations and restrictions. The annuity’s seller, or insurance company, invests in stocks and bonds. It guarantees a minimum return, but also caps the maximum return. The seller, not the annuitant, decides on the investment options.

An indexed annuity provides greater opportunities for higher rewards than a fixed annuity, but lower returns than a variable annuity. At the same time, it provides more guarantees than a variable annuity. It is less risky than a variable annuity, but more uncertain than a fixed annuity. These types of annuities are complex and have many limitations not found in other types of annuities. State laws regulate indexed annuities.

While the promise of a steady stream of income during retirement is attractive, annuities may have lower rates of return than other investment products. Despite the fact that other types of investments often have higher capital gains, many people are drawn to annuities because of the payout method. Guaranteed payments offer security to retirees who are risk-averse or who fear they will outlive their savings.

Drawbacks of an annuity include that an individual cannot access money in an annuity. It is locked in for a specific period or until the annuitant reaches the age of fifty-nine and a half. A considerable surrender charge is applied for early withdrawals. Tax penalties may also be incurred. For these reasons, annuities are often poor choices as long-term investments for younger individuals. They are better choices for individuals near retirement age.

Another disadvantage is the high cost of annuities, which are typically more expensive than investing in stocks, bonds, or mutual funds. Fees and expenses often eat up 2 to 3 percent of the value of the annuity each year. Fees include a salesperson’s commission fee, administration fees, underlying fund expenses, mortality and expense charges, surrender charges, and charges for additional features.

Fixed annuities, which are not adjusted for inflation, are also not guaranteed by the Federal Deposit Insurance Corporation or other federal agencies. If the company that provided a fixed annuity goes out of business, the money could be lost. State insurance commissions regulate fixed annuities, and state guaranty funds do typically exist to protect annuity owners; however, these are limited and vary by state. Variable annuities also have no guarantees. Like any other investment, there can be substantial gains or substantial losses. Variable annuities tend to have less investment options than mutual funds.

The tax-deferred status of annuities may be either a drawback or a benefit. Withdrawals are taxed as income at the annuitant’s current income rate. This is unlike mutual funds, stocks, and bonds, which are taxed at lower capital gains rates. For those in high tax brackets, this can result in much higher taxes than if the money had not been in an annuity investment. For individuals with incomes lower than their preretirement income, this can be an advantage, as their retirement income is in a lower tax bracket.

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