An Overview Of Annuities

By Investopedia Staff AAA

Most investors share the same goal of long-term wealth accumulation. Some of us have no problem watching our investments bounce up and down from day to day, while risk-averse investors or those nearing retirement generally can't withstand short-term volatility within their portfolios. If you are this type of investor - or one who has a moderate risk tolerance - annuities can be a valuable investment tool. (Learn more, in Designating A Trust As Retirement Beneficiary.)

TUTORIAL: Retirement Planning

Today's Annuities
An annuity is a contract between you - the annuitant - and an insurance company, who promises to pay you a certain amount of money, on a periodic basis, for a specified period. The annuity provides a kind of retirement-income insurance: you contribute funds to the annuity in exchange for the guaranteed income stream of your choosing later in life. Typically, annuities are purchased by investors who wish to guarantee themselves a minimum income stream during their retirement years.

Most annuities offer tax sheltering, meaning your contributions reduce your taxable earnings for the current year, and your investment earnings grow tax-free until you begin to draw an income from them. This feature can be very attractive to young investors, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding in their investments.

Because they are a long-term, retirement planning instrument, most annuities have provisions that penalize investors if they withdraw funds before accumulating for a minimum number of years. Also, tax rules generally encourage investors to prolong withdrawing annuity funds until a minimum age. However, most annuities have provisions that allow about 10-15% of the account to be withdrawn for emergency purposes without penalty. (Find out more, in Delay In Retirement Savings Costs More In The Long Run.)

How They Work
Generally speaking, there are two primary ways annuities are constructed and used by investors: immediate annuities and deferred annuities.

With an
immediate annuity, you contribute a lump sum to the annuity account and immediately begin receiving regular payments, which can be a specified, fixed amount or variable depending upon your choice of annuity package and usually last for the rest of your life. Typically, you would choose this type of annuity if you have experienced a one-time payment of a large amount of capital, such as lottery winnings or inheritance. Immediate annuities convert a cash pool into a lifelong income stream, providing you with a guaranteed monthly allowance for your old age.

Deferred annuities are structured to meet a different type of investor need - to contribute and accumulate capital over your working life to build a sizable income stream for your retirement. The regular contributions you make to the annuity account grow tax sheltered until you choose to draw an income from the account. This period of regular contributions and tax-sheltered growth is called the accumulation phase.

Sometimes, when establishing a deferred annuity, an investor may transfer a large sum of assets from another investment account, such as a pension plan. In this way the investor begins the accumulation phase with a large lump-sum contribution, followed by smaller periodic contributions. (Learn more about retirement, in Guaranteed Retirement Income - In Any Market.)

Perks of Tax Deferral
It is important to note the benefits of tax sheltering during the accumulation phase of a deferred annuity. If you contribute funds to the annuity through an IRA or similar type of account, you are usually able to annually defer taxable income equal to the amount of your contributions, giving you tax savings for the year of your contributions. Also, any capital gains you realize in the annuity account over the life of the accumulation phase are not taxable. Over a long period of time, your tax savings can compound and result in substantially boosted returns.

It's also worth noting that since you're likely to earn less in retirement than in your working years, you will probably fit into a lower tax bracket once your retire. This means you will pay less taxes on the assets than you would have had you claimed the income when you earned it. In the end, this provides you with even higher after-tax return on your investment.

Retirement Income
The goal of any annuity is to provide a stable, long-term income supplement for the annuitant. Once you decide to start the distribution phase of your annuity, you inform your insurance company of your desire to do so. The insurer employs actuaries who then determine your periodic payment amount by means of a mathematical model.

The primary factors taken into account in the calculation are the current dollar value of the account, your current age (the longer you wait before taking an income, the greater your payments will be), the expected future inflation-adjusted returns from the account's assets and your life expectancy (based on industry-standard life-expectancy tables). Finally, the spousal provisions included in the annuity contract are also factored into the equation.

Most annuitants choose to receive monthly payments for the rest of their life and their spouse's life (meaning the insurer stops issuing payments only after both parties are deceased). If you chose this distribution arrangement and you live a long retirement life, the total value you receive from your annuity contract will be significantly more than what you paid into it. However, should you pass away relatively early, you may receive less than what you paid the insurance company. Regardless of how long you live, the primary benefit you receive from your contract is peace of mind: guaranteed income for the rest of your life.

Furthermore, your insurance company - while it is impossible for you to predict your lifespan - need only be concerned with the average retirement life span of all their clients, which is relatively easy to predict. Thus, the insurer operates on certainty, pricing annuities so that it will marginally retain more funds than its aggregate payout to clients. At the same time, each client receives the certainty of a guaranteed retirement income.

Annuities can have other provisions, such as a guaranteed number of payment years. If you (and your spouse, if applicable) die before the guaranteed payment period is over, the insurer pays the remaining funds to the annuitant's estate. Generally, the more guarantees inserted into an annuity contract, the smaller the monthly payments will be. (Read 7 Counterintuitive Retirement Strategies That Work for more insight.)

Fixed and Variable Annuities
Different investors place different values on a guaranteed retirement income. For some, it is critical to secure a risk-free income for their retirement. Other investors are less concerned about receiving a fixed income from their annuity investment than they are about continuing to enjoy the capital gains of their funds. Which needs and priorities you have will determine whether you choose a fixed or variable annuity.

A fixed annuity offers you a very low-risk retirement - you receive a fixed amount of money every month for the rest of their life. However, the price for removing risk is missing out on growth opportunity. Should the financial markets enjoy bull market conditions during your retirement, you forgo additional gains on your annuity funds.

Variable annuities
allow you to participate in potential further appreciation of your assets while still drawing an income from your annuity. With this type of annuity, the insurance company typically guarantees a minimum income stream, through what is called a guaranteed income benefit option, and offers an excess payment amount that fluctuates with the performance of the annuity's investments. You enjoy larger payments when your managed portfolio renders high returns and smaller payments when it does not. Variable annuities may offer a comfortable balance between guaranteed retirement income and continued growth exposure.

Conclusion

Annuities offer tax-sheltered growth, which can result in significant long-term returns for you if you contribute to the annuity for a long period and wait to withdraw funds until retirement. You get peace of mind from an annuity's guaranteed income stream, and the tax benefits of deferred annuities can amount to substantial savings. Finally, variable annuities allow less risk-averse retirees prolonged exposure to the financial markets. Be sure to consider annuities as part of your overall investment strategy, as they may add value to your retirement in more ways than you think. (Learn to plan ahead, inRetirement Savings Tips For 18- To 24-Year-Olds.)

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