What Are Annuities?

An annuity is a tax-deferred savings vehicle set up using a contract between a person or entity (contract owner) and an insurance provider or broker.

The contract owner then contributes money (funds the annuity) with an optional step of accumulating additional money over time by earning interest (accumulation phase), after which the annuity issues payments to a designated person on a pre-defined schedule (payout phase or distribution phase).

Annuities have been in use since Roman soldiers were paid an annual stipend (annua in Latin) for their service. Some annuity contracts can provide a safe and reliable foundation for retirement budgets. Two modern examples of annuities are the Social Security program and employer-funded pensions.¹

Annuities are used to ensure a steady source of retirement income, to reduce your tax burden, and to pass along more of your estate to your heirs. They can be structured in many different ways, so it’s essential to be clear about both your future goals and your current circumstances before you commit to placing your money in an annuity.

The video below provides an overview of Annuities.

Annuities can be characterized as immediate or deferred; this refers to how soon payout begins.

An immediate annuity is usually created by paying a one-time lump sum, then the payout begins within a period of months. You might choose this type of annuity in order to convert a lump sum such as lottery winnings or an inheritance into a secure long-term income stream.²

A deferred annuity has two distinct phases. The accumulation phase is the time period in which you can make premium payments to fund the annuity, and accumulated funds earn interest. The payout phase is the time period during which you will receive payments from the annuity.³

Deferred annuities can be a way to increase your tax-deferred savings if you have maxed out other vehicles such as IRA and 401(k) accounts.⁴ Non-qualified annuities, which don’t have required minimum distributions, can ensure steady retirement income after other retirement accounts are depleted.⁵

Whether immediate or deferred, an annuity’s payout phase can be structured to last for a specific number of years, or for the lifetime of the annuitant, or it may continue with payments to a beneficiary after the annuitant’s death.

You can choose from fixed, indexed, or variable annuities; this refers to how the money accumulates.

A fixed annuity guarantees a minimum rate of return, regardless of the market’s performance. Whereas some fixed annuities may change this guaranteed minimum rate after a certain number of years; a multi-year guaranteed annuity (MYGA) is a fixed annuity that pays the same rate of return for the entire duration of the contract.⁶

Indexed annuities – such as a fixed indexed annuity (FIA) or an equity indexed annuity (EIA) -- guarantee a baseline rate of return, plus an additional component tied to the performance of a market index such as the S&P 500 or the Nasdaq. They offer a reliable income stream, immunity from market downturns, and some proportion of the gains during periods when the market rises. When choosing among different products, be aware of how those gains are calculated (the return rate) and how much of the gains are passed along to you (the participation rate or the margin), as well as whether your gains will be capped at a certain level. ⁷



The video below can help you understand more about fixed index annuities.



A variable annuity offers a selection of underlying funds and other investment vehicles into which you can apportion money. Because you are actively investing in market products, a variable annuity exposes your money to market risk, but you also have a chance to earn more in a rising market. The payments you receive will vary according to the rate of interest you earn during each payment period. There is a chance you will lose capital if the market dips, or if your earnings don’t keep pace with the annual fees.

One advantage of a variable annuity is the ability to move money into different underlying funds, essentially changing your investment strategy without incurring capital gains taxes. Variable annuities can pass tax-deferred savings to an heir, bypassing probate.⁸

The video below can help you understand more about variable annuities.

Annuities can be structured in different ways to suit your personal financial goals.

It can be helpful to clarify your financial goals before shopping for an annuity. Are you after a steady, reliable retirement income? Do you wish to ensure that your spouse or child has adequate resources after you are gone? Are you aiming to reduce your tax burden now and allow your money to grow more quickly? Structuring an annuity to do precisely what you want may come at a cost (higher fees or less liquidity, for instance), which should be weighed against how important each feature is to you.

It’s important to select a qualified provider, since an annuity contract can last for years or even decades. You can check a company’s financial health ratings online at credit bureaus including Moody’s, Standard & Poor’s, and A.M. Best. In the unlikely event that an annuity provider does become insolvent, the state guaranty association provides a backstop for annuities up to a certain amount.

You can minimize your risk by dividing an amount above your state’s coverage limit into smaller annuities purchased from several providers. Multiple annuities can also allow you to capture gains with a longer term of accumulation in one annuity while supplementing your income in the short term with a different annuity, making your retirement plan more robust.⁹

The calculator below can help you get a feeling for some of the tax advantages of a fixed annuity.

Citations.

1 - marketwatch.com/story/do-as-the-romans-did-with-annuities-2013-06-04

2 - fool.com/knowledge-center/what-is-an-immediate-annuity.aspx

3 - investopedia.com/terms/d/deferredannuity.asp

4 - money.usnews.com/investing/investing-101/articles/things-you-need-to-know-now-about-annuities

5 - blackrock.com/us/individual/education/retirement/what-is-an-annuity

6 - finance.yahoo.com/news/multi-guaranteed-annuity-myga-161453804.html

7 - sec.gov/oiea/investor-alerts-and-bulletins/ib_indexedannuities

8 - sec.gov/investor/pubs/sec-guide-to-variable-annuities.pdf

9 - investopedia.com/terms/a/annuity-ladder.asp