Simple Explanation of Annuities

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Annuities are investment vehicles issued by insurance companies primarily to provide income during retirement. They come with a number of different options that can be tailored to fit the investor's cash flow and future income needs. Some annuities provide guaranteed income while others invest in market-sensitive vehicles, such as mutual funds.

Annuities do have certain restrictions and fees that may affect their suitability for you.

Definition

An annuity is an agreement between an insurance company and an individual whereby the individual either makes a series of payments that can be fixed or flexible or a lump-sum payment to purchase the annuity. The issuer agrees to then make regular payments, which can begin immediately or at a future date, to the annuitant. A major benefit of annuities is that the earnings will accumulate tax-free, resulting in a faster compounded rate of growth.

Annuities generally fall into two types: fixed and variable.

Fixed

A fixed annuity guarantees fixed-amount income payments over the life of the contract. The investment will earn interest at the rate specified in the contract during the premium-accumulation period. The initial interest rate will be the current market rate, but the issuer guarantees that the rate will never be below a specified minimum. Most fixed annuities will reset the interest rate periodically, such as every three or five years. The contract terms set the amount of future income payments, and these will typically not change.

Variable

Variable annuities offer a wide choice of investment options. Depending on the investor's tolerance for risk, the funds can be invested, usually in mutual funds, stocks, bonds, money-market instruments, or any mix of these. These investments do not have any guarantees, and their value will fluctuate with market changes. The payout amounts can be fixed or variable depending on the changing value of the investment account. The Securities and Exchange Commission (SEC) defines variable annuities as securities and regulates them.

A special kind of variable annuity is the equity-indexed annuity. Its returns are based on the performance of a market index, such as the Dow Jones Industrial Average or the Standard & Poor's 500 Composite Stock Index. The insurance company will usually guarantee a minimum rate of return, and this rate will vary from company to company. The SEC does not regulate equity-indexed annuities.

Payout Options

Annuities are very flexible, and insurers can structure their plans to fit just about any individual's requirements, which makes them attractive for many types of investors.

An annuitant can elect to receive a specific payment amount for a set period (known as period-certain annuities) , which, for example, could be five, 10 or 30 years. If the annuitant should pass away before the end of the period, a beneficiary could receive the balance of payments.

Another option is to receive payments for a lifetime. Payments will cease at time of death, and survivors will not receive anything.

The life with period-certain option combines a lifetime annuity with a period-certain contract. If the annuitant dies during the specified time period, the beneficiary would continue to receive payments for the balance of the period.

With a joint and survivor annuity, the beneficiary would continue to receive payments until he or she dies.

Risks

Federal agencies, such as the FDIC, do not guarantee annuities. An annuity is only as good as the financial strength of the issuing insurance company. A potential purchaser should investigate the financial rating of the issuer with firms such as A.M. Best, Moody's or Fitch.

Every state has a guarantee fund that protects investors in the event of the failure of the issuing insurance company. However, these guarantees have limitations and each investor should check the laws in his state.

Fees

Annuities come with a number of different types of fees. Depending on the company, there may or may not be a large commission paid to the salesperson. The sales commission, administrative costs, guarantee fees and selling costs are typically combined into an item called the Mortality and Expense Charge.

Insurance companies make additional charges for continuing life and survivorship benefits. Early withdrawals of principal, usually within the first seven years of the contact, will incur a substantial surrender charge.