How Do Annuities Work?

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For people approaching retirement, or who just want a dependable stream of income, annuities provide an interesting option. The annuity is an investment contract that returns regular payments to the holder, who makes an initial lump-sum payment into the account. The length and payout of annuities may vary, and the buyer can choose from many types of annuities: deferred or immediate, for example, and fixed or variable.

Why Annuities?

Holding a large amount of money for investment and assuring that those funds will allow a comfortable future can be daunting to those who have little or no experience as investors. Insurance companies have come up with the annuity, which guarantees a stream of payments to be made monthly, quarterly or annually over the life of the contract. The annuity company handles investment of the money, while the buyer of the contract gives up direct control over those funds and simply collects regular payments over the stated term.

Fixed and Variable

A crucial decision when shopping for an annuity is whether to get one that is fixed or variable. A fixed annuity assures the buyer that the payments will remain the same over the life of the annuity, which could be set for 10, 20 or 30 years. If the insurance company experiences investment losses, it's legally bound to make the fixed payments. A variable annuity pays more or less depending on the company's investment results. The buyer can select underlying investments that will render the returns more or less volatile. An annuity invested in stocks, for example, is prone to wider swings in payout than one invested in U.S. government bonds or money market securities.

Deferred Investment and Taxes

When a buyer gets into an annuity contract, he can either begin taking immediate payments or defer the income. A deferred payout that begins after the buyer reaches retirement has time to grow with investment returns; in addition, a retiree usually finds himself in a lower tax bracket than the one that applied while he was working. While the money remains in the annuity -- the accumulation phase -- there's no tax on the income and capital gains earned by the investments. When the distribution phase begins, taxes kick in on the rise in the annuity's value. Insurance companies also may guarantee a full return of the initial investment to beneficiaries if the buyer dies before the contract pays out.

Related Expenses

The downsides for annuity buyers include the high expenses that annuity companies typically charge. The expenses reduce the investment return over the life of the contract, or they raise the cost of the annuity at the outset, as do any sales charges. In addition, there may be management fees and a painful surrender charge if the buyer chooses to cash out of the annuity early.