Annuity

Annuity Definition

Annuity is a financial product offered by insurance companies which pays a regular income in the future, usually after retirement.

Returns vary depending on the type of annuity chosen by the individual.

Taxes applicable to annuities are deferred. But annuity withdrawals, whether premature or upon maturity, have tax implications.

Annuities are one of many financial products designed to offer an income to retirees, including IRAs, 401(k)s, pensions and social security.

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What is an Annuity?

The idea of making regular payouts to individuals has been around since Roman times.

Contracts known as annua were part of the Roman economy.

These contracts guaranteed payment for a fixed period of time, possibly for life, in return for an upfront investment.

In the United States, annuities have been part of the financial system since 1759, when Pennsylvania chartered the Corporation for Relief of Poor and Distressed Presbyterian Ministers and Distressed Widows and Children of Ministers.

The corporation paid out annuities to the families of working Ministers.

Annuities can be considered as a reverse form of life insurance.

The idea behind both product types is the same – pooling mortality risk across a group and investing the cash in other products to enable a predictable cash flow for payouts.

While annuities make the payouts during an individual’s lifetime, insurance policies are generally meant to benefit the individual’s relations after death.

The main purpose of an annuity is to allow individuals to secure a steady cash flow after retirement.

The individual funds the annuity with either a lump sum or periodic payments, and the annuity provides a stream of income for either a designated period of time or the remainder of the annuitant’s life.

Annuity operations can be divided into two phases: accumulation and payouts.

During the accumulation phase, an individual makes payments to the annuity issuer.

The insurance company subsequently makes payments to the individual in the payout phase.

In general, annuity payouts depend on the time period.

The longer the time period for an annuity, the lesser the payout amount.

Annuity payouts can begin immediately after the annuitant puts down their initial lump sum payment, or they may be deferred to allow the principal to grow before the annuitant specifies a time or age at which the payments will begin.

Types of Annuities Explained

Annuities can be customized based on individual requirements.

As such, there are several different types of annuities available in the market. Broadly, however, they can be classified into three main types.

Fixed annuities make payouts based on a fixed interest rate for a fixed duration.

At the end of the annuity’s time period, if the annuitant chooses to renew the annuity, a new rate, known as renewal rate, is applied.

Fixed annuity is the safest of the three annuities, but returns tend to be modest.

There are two main types of fixed annuity: life annuity and term certain annuities.

The former type makes payments for the life term of the annuitant while the latter makes periodic payments, generally monthly, for a fixed term.

Fixed annuities can have insurance components built into their structure.

For example, they might include provisions for beneficiaries in case of the annuitant’s death. Such annuities are regulated by state insurance commissions.

Variable annuities offer a variable return on investment based on the performance of the annuity’s underlying portfolio.

Variable annuities can offer the highest return, but also carry the greatest risk.

They have a relatively complex structure as compared to fixed annuities because they tack on multiple fees and offer a menu of investment options in mutual fund-like accounts to the annuitant.

Returns from the annuity are based on an annuitant’s choice of investments.

The third type of annuities are indexed annuities. Like variable annuities, they are partly an investment product.

As their name indicates, indexed annuities returns are tied to the performance of an index, such as the S&P 500.

But they also offer a guaranteed minimum payment to allay the risk of losses in the index’s performance.

Thus, indexed annuities are considered a relatively safer bet as compared to variable annuities.

Annuities and Taxes

Annuity investment is generally linked to retirement planning.

Depending on the type and form of annuity, tax treatments can vary.

Some annuities offer the benefit of tax-deferral while others may be taxed at the regular capital gains tax rate.

For example, a deferred variable annuity defers your trading taxes, even as you shift between mutual fund accounts.

But premature withdrawal of funds from the account will result in application of capital gains taxes.

Immediate annuity offers the prospect of tax-free payouts for a principal amount as long as it corresponds to the Internal Revenue Service’s assessment of your life expectancy.

For example, if you have an immediate annuity for $50,000 for a ten-year period, then the annual payouts are $5,000.

If the IRS has set your life expectancy at 50, then $1,000 of the total payout is tax-free and the remaining $4,000 is subject to regular income tax.

Annuity Fees

Because of their complex structure that spans insurance and investment, variable and indexed annuities can have a complicated fee structure.

Here are a couple of subheads that you can expect to find in your variable annuity fee schedule.

  • Mortality and expense risk charge: This is the insurance portion of your variable annuity and equals a percentage of your mutual fund account value. The profits generated from this charge, which is reinvested into the markets, are used to pay commissions to the annuity agent.
  • Administrative fees: This is the fee charged by your annuity issuer for their administrative expenses and can either be a flat annual fee or a percentage of your account value.
  • Fund expenses: This is the fee relating to the administrative and other fund expenses in the mutual fund account that is part of your variable annuity.
  • Fees and charges for other features: A bunch of other fees, such as initial sales loads and fees to transfer between investment options, are also charged by annuity issuers.
  • Penalty fees: Insurance companies charge penalty fees for premature withdrawal. This fee encompasses 10% tax penalty to the Internal Revenue Service and taxes on income generated through the account.

Are Annuities a Good Investment Option?

While fixed annuities can be a simple investment option for individuals, variable and indexed annuities have a mixed record.

The complex structure of the latter group of products means that annuitants may be saddled with multiple line items as fees for services.

Variable annuities promise principal protection or guaranteed principal payouts, even if the value of your investments fall.

But there are several conditions attached to this type of protection.

For example, your funds are locked in for the annuity period and premature withdrawal is accompanied with fee penalties.

They also do not provide as many tax advantages as other investment options.

For these reasons, financial professionals have varying recommendations as far as annuities are concerned.

Some counsel that investment in such instruments should be done only after you have reached a minimum floor in other, more secure choices, such as Social Security and pensions.

Others recommend avoiding annuities entirely because of hefty fees, lack of liquidity, and overall complexity.

It is always a good idea to seek an investment advisor’s perspective before taking a decision regarding annuity investment.

Annuities FAQs

An annuity is a financial product offered by insurance companies designed to pay a stream of income in the future, usually after retirement.
The 3 main types of annuities are: fixed annuities, variable annuities, and indexed annuities.
Fixed annuities are the safest of the 3 types of annuities, however the returns tend to be modest.
Financial professionals often recommend avoiding annuities because of hefty fees, lack of liquidity, and overall complexity.