Reference Library

Topics include education, estate, insurance, investment, retirement and risk management planning as well as basic tips for budgeting.

Investment Planning


What is an annuity?

Simply stated, an annuity is a contract between you and an insurance company in which you pay a sum of money, either in a lump sum or through periodic contributions, and in return receive regular payments for life or for a stated period of time.

The money grows on a tax-deferred basis until you begin receiving it, typically after age 59 1/2. Annuities are especially appealing during your retirement years because they help offer protection against outliving your assets.

Annuities are often confused with life insurance, but they are not the same. Once an annuity is converted into payments (annuitized), it can provide a steady stream of income while you are alive; a life insurance policy pays off upon your death and benefits your heirs.

Annuities differ from CDs and government bonds as well, since they are not federally insured or guaranteed. With an annuity, you must depend on the financial strength of the insurance company. Insurance company financial strength is rated by various service companies such as A.M. Best or Moody's. You may want to consider only those insurance companies that carry an A or A+ rating.

There are two basic types of annuities: fixed and variable.

Fixed Annuities

Fixed annuities can pay a fixed rate of interest for a certain period, usually one to five years. After the guarantee period is over, your assets are automatically rolled over for a new time period at a new rate. The new rate will have moved up or down, depending on the general direction of interest rates. Most fixed annuities have a "floor" or guarantee below which your return will not drop. This floor, often tied to the Treasury bill rate or other index, lasts the life of the annuity.

In general, a fixed annuity is characterized by:

  • Tax-deferred fixed interest rates during the accumulation (growth) phase.
  • Fixed payments during the income (distribution) phase.
  • Return of principal (the amount you invested) guaranteed by the insurance company. The ability for the insurance company to meet these obligations to policyholders are subject to sufficient capital, liquidity, cash flow and other resources of the insurance company.
  • Risk/return: Fixed annuities generally offer a lower return than variable annuities, but also carry a lower level of risk.

There are several hybrids of fixed annuities to choose from including the Market Value Adjusted Annuity (MVA), the Single Premium Deferred Annuity (SPDA), the CD-type annuity and the Fixed Index Annuity.

Variable Annuities

Variable annuities are essentially an insurance contract combined with an investment product. Through a professionally managed "subaccount" (similar to a mutual fund portfolio) within your variable annuity, you invest in stocks, bonds or money market funds or a combination thereof.

Depending on market fluctuations, the performance of these investments will vary, hence leading to a variable return on the annuity. The insurance company does not guarantee a specified rate of return, nor does it guarantee a return of the principal. Your return could potentially be higher than a fixed annuity, but your risk is higher too.

In general, a variable annuity is characterized by:

  • Variable rates of return during the accumulation (growth) phase
  • Principal not guaranteed by the insurance company
  • Payments that vary depending on the performance of the underlying investment option(s)
  • Death benefit: Most variable annuities provide a guaranteed death benefit. This assures that the owner's heirs will receive at least the sum of all premiums paid less any withdrawals. More liberal guaranteed death benefits may be available.

An added risk protection is that variable annuity assets are held in a separate account of the insurance company. Thus, the assets are more protected from the claims of the insurance company's creditors.

The separate account of a variable annuity is not a mutual fund. While separate accounts may have a name similar to a mutual fund, it is not the same pool of funds and will experience different performance than the mutual fund of the same or similar name. In addition the financial ratings of the issuing insurance company do not apply to any non-guaranteed separate accounts. The value of the separate accounts that are not guaranteed will fluctuate in response to the market changes and other factors.

At a Glance: Fixed vs. Variable Annuities

Fixed Variable
Investor's Principal Guaranteed by the insurance company Not guaranteed, but usually pays a minimum death benefit
Rate of Return Fixed; minimum rate for life of contract, additional interest credited periodically Varies depending on portfolio performance
Investment Options None Investor has multiple choices
Investment Risk Insurer is at risk Investor is at risk
Where assets held Insurance company general account Insurance company separate account so less exposure to company's creditors

Accessing Your Annuity

For most tax types, it is more advantageous not to take payments from an annuity until the age of 59 1/2, There are several ways your money can be returned to you:

  • Lump sum
  • Regular monthly payments for a specified period of time or
  • Lifetime income for you and your spouse

Annuity payments vary depending on:

  • Amount you have contributed
  • Your age
  • Length of time your money has been compounding
  • Rate of return on the portfolios

If you don't need the income stream your annuity can provide, it can pass to your beneficiaries outside the probate process (although the proceeds will be taxable to them).

Penalties and Surrender Charges

Taking payments from your annuity before age 59 1/2 can be expensive since the IRS imposes a 10% penalty on the monies withdrawn in most cases.

Due to the 10% IRS penalty for money taken out before you reach age 59 1/2, most insurance companies allow you to withdraw up to 10% of your assets before they impose a surrender charge.

The combination of surrender charges and a possible 10% penalty means that you may want to view an annuity as a long-term investment.

Actual investment return and principal value of both investments will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. The U.S. Securities and Exchange Commission has suggested to investors (Investor Tips: Variable Annuities) that since a tax-qualified retirement plan (e.g., 403(b) plan) already has tax-deferral advantages, for most investors it would be advantageous to make the maximum allowable contribution to a tax-qualified retirement plan before investing in a variable annuity. Variable annuities differ from mutual funds in that they provide lifetime income payments and death benefit protection. A plan of regular investing does not assure a profit or protect against loss in a declining market. You should consider your financial ability to continue your purchase throughout periods of fluctuating price levels. Please obtain a prospectus for complete information including charges and expenses. Read it carefully before you invest or send money. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.

In reference to general account obligations and guarantees, such as is present with fixed annuities, the ability for the insurance company to meet these obligations to policyholders are subject to sufficient capital, liquidity, cash flow and other resources of the insurance company. A variable annuity is an insurance contract which offers three basic features: (1) annuity payout options that can provide guaranteed income for life; (2) a death benefit; and (3) tax-deferred treatment of earnings. The value of the separate account of variable annuities is not guaranteed and will fluctuate in response to market changes and other factors. Variable annuities are designed to be long-term investments and early withdrawals may be subject to tax penalties and charges.

Looking for more information?

* Indicates required field

You must check the I'm not a robot checkbox.

Thank you for contacting Lincoln Investment!