Annuities Basics

Annuities are financial products intended to enhance retirement security. An annuity is an agreement for one person or organization to pay another a series of payments. Usually the term “annuity” relates to a contract between an individual and a life insurance company. There are many categories of annuities. They can be classified by:

Nature of the underlying investment: fixed or variable
Primary purpose: accumulation or pay-out (deferred or immediate)
Nature of payout commitment: fixed period, fixed amount or lifetime
Tax status: qualified or nonqualified
Premium payment arrangement: single premium or flexible premium An annuity can be classified in several of these categories at once.

For example, an individual might buy a nonqualified single premium deferred variable annuity. In general, annuities have the following features:

1. Tax Deferral on Investment Earnings

Many investments are taxed year by year, but the investment earnings—capital gains and investment income in annuities are not taxable until the investor withdraws money.

This tax deferral is also true of 401(k)s and IRAs; however, unlike these products, there are no limits on the amount one can put into an annuity. Moreover, the minimum withdrawal requirements for annuities are much more liberal than they are for 401(k)s and IRAs.

2. Protection from Creditors

People who own an immediate annuity (that is, who are receiving money from an insurance company), are afforded some protection from creditors.

Generally the most that creditors can access is the payments as they are made, since the money the annuity owner gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities.

3. A Variety of Investment Options

Many annuity companies offer an array of investment options. For example, individuals can invest in a fixed annuity that credits a specified interest rate, similar to a bank Certificate of Deposit (CD). If they buy a variable annuity, their money can be invested in stocks, bonds or mutual funds.

In recent years, annuity companies have created various types of “floors” that limit the extent of investment decline from an increasing reference point.

4. Taxfree Transfers Among Investment Options

In contrast to mutual funds and other investments made with aftertax money, with annuities there are no tax consequences if owners change how their funds are invested. This can be particularly valuable if they are using a strategy called “rebalancing,” which is recommended by many financial advisors.

Under rebalancing, investors shift their investments periodically to return them to the proportions that represent the risk/return combination most appropriate for the investor’s situation.

5. Lifetime Income

A lifetime immediate annuity converts an investment into a stream of payments that last until the annuity owner dies. In concept, the payments come from three “pockets”: The original investment, investment earnings and money from a pool of people in the investors group who do not live as long as actuarial tables forecast.

The pooling is unique to annuities, and it is what enables annuity companies to be able to guarantee a lifetime income.

6. Benefits to Heirs

There is a common apprehension that if an individual starts an immediate lifetime annuity and dies soon after that, the insurance company keeps all of the investment in the annuity. To prevent this situation individuals can buy a “guaranteed period” with the immediate annuity.

A guaranteed period commits the insurance company to continue payments after the owner dies to one or more designated beneficiaries; the payments continue to the end of the stated guaranteed period—usually 10 or 20 years (measured from when the owner started receiving the annuity payments).

Moreover, annuity benefits that pass to beneficiaries do not go through probate and are not governed by the annuity owner’s will. Types of Annuities There are two major types of annuities: fixed and variable. Fixed annuities guarantee the principal and a minimum rate of interest.

Generally, interest credited and payments made from a fixed annuity are based on rates declared by the company, which can change only yearly. Fixed annuities are considered “general account” assets.

In contrast, variable annuity account values and payments are based on the performance of a separate investment portfolio, thus their value may fluctuate daily. Variable annuities are considered “separate account” assets. There are a variety of fixed annuities and variable annuities.

One example, the equity indexed annuity, is a hybrid of the features of fixed and variable annuities. It credits a minimum rate of interest, just as other fixed annuities do, but its value is also based on the performance of a specified stock index usually computed as a fraction of that index’s total return.

In December 2008 the Securities and Exchange Commission voted to reclassify indexed annuities (with some exceptions) as securities, not insurance products. Annuities can also be classified by marketing channel, in other words whether they are sold to groups or individuals.

Annuities can be deferred or immediate. Deferred annuities generally accumulate assets over a long period of time, with withdrawals usually as a single sum or as an income payment beginning at retirement. Immediate annuities allow purchasers to convert a lump sum payment into a stream of income that the policyholder begins to receive right away.

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