An annuity is a contract between an investor and an insurance company. The investor gives the insurance company either a lump-sum premium, which is also known as a single premium, or he or she provides multiple premiums over time. The time during which he or she makes multiple payments is called the accumulation phase. In exchange for the premiums, the annuity owner receives payouts for life that are guaranteed. This is called the distribution phase. The payouts are distributed monthly, quarterly or annually, depending on the choice made by the annuity owner. The start date and the amount of the payouts depend on the kind of contract.

An annuity can be fixed, variable or indexed. These can be either immediate or deferred. The kind of annuity that is right for an investor depends on several factors, including the number of years before retirement, the amount of income that he or she will receive from other sources and the other assets such as savings accounts, equities and real estate.

The Fixed, Variable and Indexed Annuity Definition

The premium for each type of annuity is invested in the equity or bond markets or a combination of the two. However, the risks incurred by each kind of annuity are different.

Fixed annuities pay a set return, regardless of fluctuations in domestic and foreign stock, bond and credit markets. The premium paid by the investor to the insurance company is invested in very conservative mutual bond funds. The bond funds typically own United States Treasuries. They may also include highly rated state and municipal bonds, along with low-risk corporate bonds. Some insurance companies will offer a guaranteed fixed return anywhere between 2% and 6% of the total principal. While this seems like an advantage when yields on treasuries are low, it may not be enough to beat inflationary pressures that will erode an investor’s purchasing power.

The returns paid on a variable annuity depend on how an investor decides to invest the premium. He or she can usually choose from a number of different mutual fund types, from very conservative or very aggressive funds, or he or she can choose a combination of the two, depending on his or her tolerance for risk. As with almost all other financial products, higher reward potential usually means taking on more risk. For those investors interested in variable annuities, awareness that principal could be lost in market downturns should always be known. But, it’s also possible that the annuity account can grow more quickly than other types of investments.

An indexed annuity is tied to a market index, most commonly the Standard and Poor’s 500. The S&P 500 is the broadest of the markets and measures the 500 largest companies by equity capitalization. Because it is large and broad, an S&P 500 indexed annuity spreads the risk of loss over all market sectors. The premium paid for an indexed annuity is put in an index fund.

The returns are then based on the performance of the entire index. In other words, while stocks in the “Consumer Discretionary” sector might be lower, those in another category may have risen. An investor in an indexed annuity should always be prepared to take a loss, as the loss of principal might occur with a market downturn. Further, almost all insurance companies will cap the maximum amount that they will pay as part of the payout. If the cap is 7%, only 7% will be paid out even if the S & P 500 increases by 9% during the year.

Fixed annuities are usually sold as immediate annuities. This means that the payouts begin within 12 months of the contract start date. Immediate annuities are also typically bought with after-tax dollars from a checking account, the death benefit of an insurance policy or with the money made on the sale of property. An indexed or variable annuity can also be an immediate annuity, but these are usually deferred annuities.

Deferred annuities are those for which the taxes and distributions are deferred, usually until after retirement. A deferred annuity can be part of an employer sponsored defined contribution plan like a 401(k) or it can be bought by an individual. A deferred annuity is a good way for those who have maxed out their qualified plans to save more money for retirement.

Annuity Definition and Financial Needs

The biggest financial need that is met by an annuity is a guaranteed stream of income after retirement. As Americans live longer and face increases in health care expenses, they risk outliving their retirement savings. Because all annuities grow tax-deferred, it means that the interest credited to the account accumulates faster because none of it is deducted to pay taxes. Once distributions begin, the earnings are subject to taxation. However, the amount of the payout that represents a return of the premium is not subject to being taxed. Therefore, annuities enjoy a special tax status that is far better than other types of investments.

What Type of Investor is Best Suited for Annuities?

Most insurance companies offer a “free look” period during which an annuity investor can decide to cancel the contract without penalty. However, once the contract is signed, it cannot be cancelled. The premium cannot be returned except in the form of payouts in accordance with the contract. An annuity is best suited for an investor who will be able to keep enough cash to meet financial needs not being covered by the annuity payouts. Financial advisors, both those who are independent brokers and those who work for insurance companies, often advise an investor to make sure that he or she has at least $25,000 to $50,000 in liquid cash reserves after funding the immediate annuity.

Professionals who are subject to various legal risk, should also consider the benefits of an annuity as most states consider annuities as irrevocable contracts.

Investors in annuities have a number of options for receiving the distribution of their funds. The three most common forms of distribution—all of which have various costs deducted—are lump sum, lifetime income, and systematic payout. Some investors who have contributed to a variable annuity over many years may elect to make a lump sum withdrawal. The main drawback to this approach is that all the taxes are due immediately. Other investors may decide upon a systematic payout of the accumulated assets over a specified time period. In this approach, the investor can determine the amount of payments as well as the intervals at which payments will be received. Finally, some investors choose the option of receiving a guaranteed lifetime income. This option is the most expensive for the investor, and does not provide any money for heirs, but the sponsor of the annuity must continue to make payouts even if the investor outlives his or her assets. A similar distribution arrangement is joint-and-last-survivor, which is an annuity that keeps providing income as long as one person in a couple is alive.

Annuities are rather complex financial products, and as such they have become the subject of considerable debate among experts in financial planning. As mentioned earlier, many experts claim that the special features of annuities are not great enough to make up for their cost as compared to other investment options. Financial advisors commonly suggest that individuals maximize their contributions to IRAs, 401(k)s, or other pre-tax retirement accounts before considering annuities (investors should avoid placing annuities into IRAs or other tax-sheltered account because the tax shelter then becomes redundant and the investor pays large annuity fees for nothing). Some experts also prefer mutual funds tied to a stock market index to annuities, because such funds typically cost less and often provide a more favorable tax situation. Contributions to annuities are taxed at the same rate as ordinary income, for instance, while long-term capital gains from stock investments are taxed at a special, lower rate—usually 20 percent. Still other financial advisors note that, given the costs involved, annuities require a very long-term financial commitment in order to provide benefits. It may not be possible for some individuals to tie up funds for the 17 to 20 years it takes to benefit from the purchase of an annuity.

Annuities can be beneficial for individuals in a number of different situations. For example, annuities provide an extra source of income and an added margin of safety for individuals who have contributed the limit allowed under other retirement savings options. In addition, some kinds of annuities can be valuable for individuals who want to protect their assets from creditors in the event of bankruptcy. An annuity can provide a good shelter for a retirement nest egg for someone in a risky profession, such as medicine. Annuities are also recommended for people who plan to spend the principal during their lifetime rather than leaving it for their heirs. Finally, annuities may be more beneficial for individuals who expect that their tax bracket will be 28 percent or lower at the time they begin making withdrawals.

Annuities may also hold a great deal of appeal for small businesses. For example, annuities can be used as a retirement savings plan on top of a 401(k). They can be structured in various ways to reward employees for meeting company goals. In addition, annuities can provide a nice counterpart to life insurance, since the longer the investor lives, the better an annuity will turn out to be as an investment. Finally, some annuities allow investors to take out loans against the principal without paying penalties for early withdrawal. Overall, some financial experts claim that annuities are actually worth more than comparable investments because of such features as the death benefit, guaranteed lifetime income, and investment services.