What is an Annuity?

An annuity is a contract between you (the purchaser or owner) and an insurance company. In its simplest form, you pay money to an annuity issuer, and the issuer then pays the principal and earnings back to you or to a named beneficiary. Annuities are generally used to provide income in retirement.

Most life insurance companies sell annuities. You pay the insurance company a sum of money, either all at once or incrementally. The type of annuity you own determines whether your money earns a fixed amount or an amount that depends on the equities in which the annuity is invested. At a designated time chosen by you, known as the maturity date, the insurance company generally begins to send you regular distributions from the annuity's account. Or, you may be able to withdraw the money over time or in one lump sum.

Types of Annuities

Annuities can be divided into two types: fixed and variable.

Fixed annuities pay guaranteed dividends at set disbursement rates.  This typically offers guaranteed payments over the course of the buyer’s life, based on the amount of the investment.

Variable annuities offer a range of investment options with returns depending on the performance of the investments. Mutual funds are a popular form of variable annuities.

Hybrid annuities combine both fixed and variable annuities, allocating investments according to buyers’ needs.

Types of Fixed Annuities

Life annuities:  These typically pay out over the course of the buyer’s lifetime in exchange for a lump sum payment or periodical payments.

Term certain annuities: These pay out to the holder over the course of a specified period of time.

Types of Variable Annuities

Immediate:  These pay benefits as soon as the annuity is purchased. A Single Premium Immediate Annuity (SPIA) pays benefits on a one-time investment as soon as it is made.

Deferred:  Annuities that pay out following an accumulation phase. A Single Premium Deferred Annuity (SPDA) pays benefits on an investment at a date of the investor’s choosing.

Immediate annuities are better suited for buyers who want a return on their purchase right away.

Deferred annuities work as savings vehicles for those who want to paid out at a later date, such as after they retire.

Equity-Indexed Annuities

Equity-index annuities tie benefits to the performance to stock indexes.  These annuities often provide guaranteed minimum payouts to annuity holders.

Equity-indexed annuities are tied to indexes such as the S&P 500 or the Dow Jones Industrial Average, so your investment grows as the value of the market grows over time.

Indexing Methods

Annuities can be indexed to equity markets in a number of ways.

Annual resent means that interest rates are based on increases in index values over the course of a year.

Point-to-Point indexing bases interest rates on changes from the beginning to the end of the contract’s duration.

High Water Mark indexing calculates rates on high points in the equity index between the beginning of the contract and various points throughout the annuity’s term.

Bonus Annuities

As an incentive against early withdrawal, some annuities offer purchasers bonuses for staying invested longer.  This bonus is usually a percentage of the annuity’s total value.

Some bonus annuities allow holders to withdraw a portion of the investment before the payout date.  However, once withdrawn, the money can be subject to taxes and surrender charges.

No-Surrender Annuities

No-surrender annuities carry no withdrawal penalties, offering investors access to their money at any point during an annuity’s term.  However, most do not offer bonuses for longer investments, and early withdrawals will still be liable for taxes if investors are younger than 59 years old.

Structured Settlement Annuities

This type of annuity is designed for those who have been victims of accidents in which they are not at fault.  In these cases, an injury settlement, instead of being paid in a lump sum, is distributed in the form of multiple payments over a set time period.

The advantage of a structured settlement annuity is that it spreads an injury payment out over a period of time, providing a continuing benefit during a period of recovery.  A structured settlement annuity also helps the holder avoid large tax deductions, which can be taken from a lump-sum payment.

Annuity Fees

Mortality and Expense (M&E):  This charge covers guarantees on the annuity and basic administration costs for the policy seller.  It is usually a small percentage of the annual value of the annuity.

Surrender:  Usually a percentage of the value of the annuity, surrender charges are paid when the annuity is cashed in before the time specified in the annuity contract.

Management: A percentage of the annuity’s value paid to manage the investment.