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What is an annuity? Definition, types, pros and cons

What is an annuity? Definition, types, pros and cons 2

  • An annuity is a contract with an insurance company. You invest a lump sum that is returned with interest in periodic payments.
  • Fixed annuities make payments based on a set interest rate. Variable and indexed annuities pay fluctuating interest rates.
  • While they offer guaranteed income and some tax advantages, annuities are illiquid and come with high fees.
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“People always live forever when there is an annuity to be paid them,” observed Jane Austen in Sense and Sensibility

An annuity isn’t literally an elixir for immortality, but Austen does have a point. For centuries, a broad range of investors has found that owning and receiving payments from an annuity has helped them —not to live longer, maybe, but to live better.

A modern-day annuity is a contract between you and an insurance company. After you pay a premium — usually a large lump sum — the insurer invests it, then provides you with a stream of payouts for a predetermined number of years or even the remainder of your lifetime. 

Since annuity payments usually begin after age 59½, annuities are considered a retiree’s vehicle, with seniors the traditional target audience. But due to certain tax-advantaged features, many are being marketed as a retirement planning and investing tool for younger people, too. 

How do annuities work?

An annuity has two phases. In the accumulation phase, you deposit funds to your account which, over time, earns a rate of return on a tax-deferred basis. In the annuitization phase, you begin to receive disbursements on a systematic schedule. 

There are two ways to invest and receive your payouts.

  • Immediate annuity: Also known as a Single-Premium Immediate Annuity (SPIA), this option has payouts ready to start in as short as a month. It is typically purchased at a one-time lump sum. The insurance company then calculates the amount due you based on your age, prevailing interest rates, and how long the payouts are expected to continue.

    It is your call if you want an income stream for a limited period or for a lifetime, and if you want payouts scheduled monthly, quarterly, or yearly. In general, the amount you receive for the whole period of your contract is fixed and guaranteed. 

  • Deferred annuity: The Deferred Payment Annuity option, as the name implies, delays the payouts until a future date. You can buy a Deferred Plan with a one-time payment or add to your funds periodically. After a length of time of your choosing — usually several years — you elect for payouts to begin.

    The tax situation’s a tad complicated, but basically, your principal — the money you initially invested — gets returned to you free of taxes. You’ll only owe the IRS on the earnings your annuity made during the deferred period. 

What are the types of deferred annuities?

There are several varieties of deferred annuities. 

  • With a fixed annuity, you’ll earn a stated interest rate on your account and be given the same unvarying payout year after year. Terms and rates vary tremendously from insurer to insurer. For instance, with Lincoln National’s MYGuarantee Plus, a 10-year annuity period requires you to deposit a minimum premium of $10,000 for an interest rate of 1.20%. Meanwhile, for the same length of annuity period, Atlantic Coast Life’s Safe Haven 10 requires you a mere $5,000 minimum premium for a 3.20% interest.

    The differences among annuities can reflect the flexibility of the contract — how long the accumulation phase, how easy it is to withdraw extra sums — and the benefits you want, such as having the payouts continue to your spouse after your death.

  • A variable annuity also offers consistent payouts, but in fluctuating amounts. During the accumulation phase, you can choose to invest in a slew of investment funds, ranging from a mutual fund of stocks to money market funds to global bonds. The money earned by these investments will vary, depending on the performance of each fund. Therefore, come the annuitization phase, the interest rate on your payout varies. 
  • An indexed annuity is a hybrid of the fixed and variable annuities. Although you receive a guaranteed minimum payout, much of your payments are tied to a particular stock index, such as the S&P 500. Your insurance company determines the value of your disbursement from there, based on annual gains in the index. So much like with a variable annuity, if financial markets perform well, so will your indexed annuity. 

What sort of investor buys annuities?

Single-Premium Immediate Annuities, the old-fashioned, traditional kind, attract senior customers. The Life Insurance and Market Research Association (LIMRA ) reports that the average age of the SPIA purchaser is 71. 

Variable and indexed annuities, on the other hand, are popular among a broader spectrum of investors — working consumers in their 50s or even their late 40s. Or anyone who’s planning to stop full-time work 10 to 15 years down the road. 

Variable annuities in particular are a good choice if you have maxed out your contributions to an IRA or 401(k), and are on the lookout for investment options.

The average age of first-time Indexed and variable annuity buyers in America is 53 with most planning to retire by the time they’re 66, according to a recent Gallup poll.

Advantages of annuities

Annuities can be rewarding for a number of reasons.

  • Regular payments: A steady flow of income is hardly the worst idea in the world, especially for a retiree. People used to receiving regular wages or those needing budgetary discipline also may appreciate getting the periodic, paycheck-like payments.
  • Tax-deferred growth: As with IRAs and 401(k)s, the funds within each of these insurance contracts grow on a tax-deferred basis. You are taxed only when you start receiving periodic payouts — on the earnings portion, at your ordinary income tax rate.
  • Low-risk returns: They’re not the FDIC, but insurance companies are pretty conservative with clients’ funds and pretty reliable at meeting their promised payouts. Of course, variable annuities’ rates will, well, vary, but some insurers do guarantee a bare-minimum return. 

Disadvantages of annuities

But annuities do come with their own list of drawbacks, too.

  • Big fees: Annuities come with lots of expenses. For a variable annuity, insurance companies charge a mortality and expense fee, a sub-account fee, and an annual contract maintenance fee. Other charges down the line include investment management fees, surrender charges, sales loads, rider charges, and death benefit fees. All of these can add up to over 3% annually. In comparison, expense ratios for exchange-traded funds and mutual funds typically range from .5% to 1%. 
  • Illiquidity: You incur a surrender fee if you try to withdraw funds or cancel your annuity contract in its first few years. Your insurance company can initially charge you as much as 10% of your contributed funds, dropping by one percentage for each consecutive year. A surrender period lasts six to eight years, sometimes even longer. And once your payouts start, it’s next to impossible to change them or access more of your principal.
  • Tax penalty: As with other retirement accounts, if you take withdrawals from your annuity before you’re 59½, you are required to pay a 10% penalty on top of your ordinary income tax.

What are alternatives to annuities?

There are, of course, other fixed-income solutions out there: Instruments like CDs and bonds — especially US Treasuries

Another option: managed payout funds, created by investment and financial services companies like Vanguard, Fidelity, and Charles Schwab specifically to compete with annuities. 

These are income funds that are designed to provide investors with equal and predictable monthly payments, like annuities. However, like mutual funds, they allow investors to access and withdraw from their accounts without penalties or surrender fees. They charge lower annual fees, too.

As investment (not insurance) vehicles, they cannot guarantee payouts or your principal; though they have a target, returns may vary. On the upside, managed payout funds have the potential to keep up with inflation — the enemy of all fixed-income investments, including annuities.

The financial takeaway

Annuities’ fees and constraints are admittedly drawbacks, especially for younger investors. But while they may not pay as much as other retirement investments, they do pay pretty reliably. In the grand scheme of investment things, annuities are low-risk animals. 

Since annuities are backed by the insurance companies themselves, it’s crucial to do your research. Know the insurer’s reputation in the industry and its financial health status. Compare service fees and surrender fees, the payouts’ relationship to interest rates, extras like death benefits and joint-and-last-survivor options. 

Each insurer has a different way of customizing your annuity — so make sure it’s customized to your tastes and financial needs.

Related Coverage in Investing:

Investment income is money earned by your financial assets or accounts, and understanding how it works can help maximize your profits

Passive investing is a long-term wealth-building strategy all investors should know — here’s how it works

Investing for income: 7 money-generating assets for your portfolio and how to get started

A million-dollar life insurance policy sounds like a lot, but you might want to consider it

Liz Weston: How to mess up a variable annuity

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