Annuity Basics

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 offer protection against outliving your assets.

Annuities are often confused with life insurance, but they are not the same. An annuity provides 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 will 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 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) and the CD-type 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 protected from the claims of the insurance company's creditors.

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 no exposure to company's creditors

Accessing Your Annuity

When you reach age 59 1/2, your money is returned to you in one of several ways:

  • 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

Cashing in your annuity before age 59 1/2 can be expensive since the IRS will impose a 10% penalty on the monies withdrawn. This 10% penalty does not apply to payments made on account of disability or death, or to certain payments that are part of a series of substantially equal periodic payments over life or life expectancy when only that portion of the payment representing growth or interest income is taxed.

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. Go beyond that 10%, and you'll be charged a fee, typically a percentage of the withdrawal that decreases depending on the age of the contract.

The combination of surrender charges and a possible 10% penalty means an annuity must be viewed as a long-term investment.