An annuity is an investment sold by life insurance companies.  An annuity is a contract between an owner and the insurance company in which the owner pays money to the company in exchange for a guaranteed stream of income to an annuitant, usually for the rest of their life.  People choose annuities for a number of reasons but the biggest reason is the safety they offer, some tax benefits of owning them, and additional features that may come with the annuity such as a death benefit.

Tax Benefits Of Annuities

Annuities all grow “tax deferred”.  This means that taxes are only due on on non-qualified annuities when gains are withdrawn, and taxes are due on qualified annuities only when money is withdrawn.  In other words, annuities can grow for decades without a dollar being paid in taxes.  Anyone who pays a lot of money in taxes every year can appreciate just how much deferring their taxes can contribute to  the growth of an investment account.  This tax deferral benefit of annuities makes non-qualified annuities a popular investment for people who would like to but cannot contribute any more money to their Roth IRA because they have reached their yearly maximum.  Just like with a retirement account, even a non-qualified annuity does not allow for tax penalty free withdrawals of gain before at 59.5.  This is the trade off the owner makes for tax deferred growth.  Any taxable withdrawal from an annuity before this age is normally subject to a 10% penalty from the IRS, though some exceptions may apply so clients should always consult with a tax adviser prior to taking withdrawals.

Annuities Can be Fixed or Variable

The two very different classes of annuities are fixed and variable.  A fixed annuity is one whose growth is predictable, and is guaranteed by the insurance company.  A fixed annuity will guarantee a minimum stream of income later, in exchange for a payment today and over a period of time into the annuity.  Many annuities will guarantee a payment for as long as the annuitant lives, regardless of how long that is.  The risk of the annuitant living a long time is borne by the insurance company, while the risk that an early death will occur is borne by the annuitant (because they would miss out on future payments).

A variable annuity is one whose value is invested in variable sub accounts, which are essentially mutual funds.  The value of a variable annuity is dependent upon the performance of these funds, and therefore is tied to the equity, bond, commodity, and real estate markets (depending on the specific funds money is allocated to).  A variable annuity, even though its performance is dependent upon the market, may still have a guaranteed return.  This is attractive to people looking for both safety with the potential for greater upside than a fixed annuity.

Fixed Annuity Contracts

There are two basic kinds of fixed annuity contracts.  The difference lies in the timing of the starting point of payments to the annuitant.  A deferred annuity is one whose payments to the annuitant (the person who receives the income from an annuity) start at a later date from when the premium is paid to the life insurance company, while an immediate fixed annuity will begin paying a stream of income to the annuitant immediately after receiving a lump sum investment from the owner.

The period when the value of a fixed annuity is growing is known as the accrual period.  During this accrual period, additional payment and usually be made into the annuity.  The amount of growth in annuity may be based upon interest rates at the time of issue, or the prevailing interest rates throughout the accrual period, or both.  A minimum guarantee regarding growth is given at the time of the contract being issued, and is sometimes based upon interest rates on the day the illustration is run, or the issue date.  Other contracts may guarantee a very low rate of return, but provide for much higher returns if interest rates remain at higher levels than the minimum.

At a determined time chosen by the owner of the contract, the life insurance company will start making payments to the annuitant.  This period of time is known as the “payout” phase of the annuity.  At the beginning of the payout period, a guaranteed amount is quoted by the life insurance company.  The payout period will normally last the entire life of the annuitant, and there are different length of time guarantees that can be chosen at the time the payout begins.  These usually mean that if the annuitant dies earlier than the chosen number of years, payments will continue for the remainder of the of time to the beneficiaries.  The longer the guaranteed payments to beneficiaries, the lower the payout will be on an annual basis to the annuitant.  This is because it is reducing the risk to the annuitant that he/she will die young.  The life insurance company is still bearing the risk that the annuitant will outlive their life expectancy, which means that more total money must be paid out by them.  The balance of this risk in conjunction with interest rates, time value, and the amount of cash put into the annuity determines how much money the insurance company pays periodically to the annuitant.

A fixed annuity contract is very useful for conservative investors, or investors who may have a lot of their risk capital allocated to more volatile investments and are looking for an investment vehicle which provides stable and predictable growth, which will presumably outpace inflation.

Variable Annuity

A variable annuity is a contract with the same structure as that of the fixed type.  There is an accrual period, during which time money invested in the annuity has the opportunity to increase in value.  Instead of this increase being guaranteed however, the increase is subject to market fluctuation and it may outperform or under perform expectations.

A variable annuity functions very much like an investment account, and all money is invested in variable sub accounts, which are essentially mutual funds within the annuity.  The value of these sub accounts are based on their underlying investments just like mutual funds, and in most cases the funds mimic popular mutual funds available to the public.  Usually there are offerings for all major asset classes in a variable annuity. The owner of a variable annuity has complete control over how the money is invested, and ultimately the performance of the annuity will depend upon how the money in the annuity is allocated across sub accounts.  Variable annuity owners should be aware that the annual charges for owning a variable annuity, known as the mortality and expense charges and administrative charges, are higher than the aggregate charges most people would pay for a brokerage account.

Variable annuities do have additional benefits over a brokerage account though.  An annuity receives preferential tax treatments, and even if an owner makes trades between sub accounts in a non-qualified annuity, there are no taxes or realized gains from trades.  There are no loads either when allocating money to the sub accounts, and there is often times a “fixed account” option which will a fixed rate of return, typically far exceeding a money market investment.  Additional riders can also be added to variable annuities which will provide either a protection of the investment value or even a minimum guaranteed rate of return if certain allocation standards are met.  A variable annuity will usually have a death benefit payable to beneficiaries, and may even include additional features such as disability riders or unemployment riders which can help the owner through hard financial times.

At the time of an owners choosing, a variable annuity contract can be annuitized, and turned into a guaranteed stream of income just like a fixed annuity.  Ultimately the amount of money paid out during the payout phase is based upon the cash value at time of annuitization, the age of the annuitant, and current interest rates.  The same options exist to guarantee different payout options to beneficiaries of variable annuities as exists for fixed annuities.

Withdrawals and Surrender Charges

Most variable annuity contracts, and some fixed contracts, allow for lump sum withdrawals of money during the accrual period.  While this is a convenience to the owner of the contract, it will often come with a cost.  Besides reducing the value of the annuity and therefore lowering the future stream of income back to the annuitant, there also may be surrender charges.  These surrender charges usually diminish as the contract ages, and a set schedule is laid out in the policy itself.  The surrender charges can become quite expensive if a lot of money is withdrawn.

To help policy owners, most companies will allow up to a certain amount of money to be withdrawn each year without any charges.  Only if the withdrawals exceed this “free amount” will surrender charges be applicable to the withdrawal.  Any surrender charges incurred go directly to the life insurance company, and will not normally be returned under any circumstances unless the withdrawal is reversed.  Always inquire about surrender charges before taking a withdrawal from an annuity.

Annuity contracts are very diverse, but they all provide certain key features.  Tax deferred growth, the ability to turn an investment into a lifetime stream of income, safety of principal, and other additional features make annuities a popular investment choice for many people.