Annuities generally consist of regular income payments that are guaranteed by an insurance company and paid out every year, helping to give these investments their name. Typically, an annuity is structured to make regular payments throughout the remainder of a policyholder's life, with the payment amount determined by an annuity formula. This is in contrast to life insurance, in which payouts are typically made after the death of the policy owner. However, there are many different kinds of annuities. Investors should understand the differences in annuity types before deciding on a particular type of contract, as they can be hard to get out of or change.
An annuity is an investment contract made between an investor and an insurance company. In exchange for one or more payments, known as premiums, the insurance company agrees to make regular payments to the investor, either immediately or at some date in the future.
Annuity Examples and Terminology
The two main types of annuities are fixed and variable. Annuities can also be categorized as immediate or deferred, and qualified or non-qualified.
Immediate annuities begin making payments shortly after a contract is purchased. A deferred annuity doesn't begin making payments until some date in the future. The period during which an annuity isn't making payments is known as the accumulation period. Once a deferred annuity becomes annuitized, it begins making payments the same as an immediate annuity would.
A qualified annuity is funded with pre-tax contributions, much like a retirement plan such as an IRA. A non-deferred annuity, which is more common, is funded with after-tax money.
Fixed and Variable Annuities
A fixed annuity pays out a specific return for a specific time period. For example, a fixed annuity might pay a 4 percent interest rate for 10 years, after which the contract matures and payments cease. Other contracts might specify payments for the life of the contract holder. In either event, fixed annuity payments typically cease upon the death of the owner.
Variable annuities, as the name suggests, pay out a variable return to investors. Unlike fixed annuities, which pay a stated interest rate, variable annuities only pay out the amount that was generated in the contract during the accumulation period. The structure of a variable annuity is what generates this unpredictable payout.
Whereas a fixed annuity is somewhat like a bond, which doesn't rise or fall in value and pays out a declared interest rate, a variable annuity acts more like a mutual fund investment. Variable annuities typically have various investment buckets that policy owners can choose where to place their funds. For example, a variable annuity might offer one investment bucket with a collection of large-cap growth stocks, another with international stocks, another with corporate bonds, and yet another with commodity investments. In fact, some variable annuities offer their own versions of well-known mutual funds, such as a S&P 500 index fund; much like a straight mutual fund investment, the value of these buckets can rise or fall based on the performance of the underlying investments.
The payout of a variable annuity is determined after the accumulation period ends and the annuitization phase begins. This conversion typically happens at the will of the policy owner. An investor who is planning on funding his or retirement with a variable annuity might, for example, purchase a contract at age 60, invest the money for 10 years, then annuitize the investment at age 70. At that point, the accumulation phase ends, and the value of the variable annuity at that point gets plugged into an annuity formula to determine the investor's monthly or annual payout.
An annuity doesn't generally have an upfront sales commission, as some mutual funds do. However, over the course of the contract, money can be deducted via various fees.
Fixed annuities often have less-visible fees than variable annuities. With a fixed annuity, an insurance company will take the premiums paid on a contract and invest that money elsewhere. The rate paid to investors is set by the insurance company at a level that ensures a profit after paying out commissions to brokers and covering general expenses. Fixed annuities also commonly carry surrender charges. A surrender charge is a fee that investors pay if they sell their annuity before a specified time period. Usually, this charge starts high and declines over time. For example, if you sell an annuity in the first year after you buy it, you might have to pay a 6 percent surrender charge that declines by 1 percent for every year thereafter, meaning if you sell in the third year after purchase, your surrender charge might be 4 percent.
Variable annuities come with a slew of fees that must be disclosed but that can sometimes be hard to quantify. The first fee is the cost of insurance. Variable annuities typically come with a death benefit, just like straight life insurance. This insurance costs money, which is taken out of the investment contract every year. The next cost is the fee for investment management. Since variable annuities manage portfolios much like mutual funds, managers need to get paid and expenses need to get covered, and policyholders are the ones that pay. A third common cost is surrender charges, just as with fixed annuities. Rider fees are assessed if you add on any additional products to a variable annuity, such as an accidental death policy or a guaranteed rising death benefit provision. Variable annuities might also have other miscellaneous fees, such as general contract charges.
Pros and Cons of Annuities
The main benefit of an annuity is that they pay an income that you cannot outlive. Except in the case of annuities with a certain term, most annuities make payments for the life of the policy owner. Having the certainty that you won't run out of income after you retire, even if you annuitize at a fairly young age like 60, can provide an important sense of security. This is particularly important in an era when people are living longer and longer in retirement.
Another important benefit of annuities is the tax-deferral of their earnings. When you invest in an annuity, you won't pay tax on any of your investment gains until you begin receiving distributions. At that point, only a portion of your payout will be taxable, based on the annuity equation that factors in your after-tax contributions.
On the downside, payouts you take from an annuity are taxable as ordinary income, even if they were generated from long-term capital gains. Since long-term capital gains have a special tax rate, you could end up paying higher taxes than if you had invested outside of an annuity.
Annuities also suffer from some other negatives, including potentially high fees and a lack of liquidity. Investing in low-cost index funds or Treasury securities will almost always cost less than buying an annuity, and you can sell those investments at any time without worrying about surrender charges. Annuities also tend to be complex investments, with new investment variations being invented all the time.
John Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to writing thousands of articles for various online publications, he has published five educational books for young adults.