As a financial professional, you already know why investing is important. But occasionally you meet a client who doesn't understand even the most basic concepts and tools of successful investing. What do you say? The following is an easy to follow explanation to help you explain to clients why they should invest in annuities.

The Purpose of Annuities

Conceptually speaking, annuities can be thought of as a reverse form of life insurance. Life insurance pays the insured upon death, while annuities pay annuitants while they are still living. The academic definition of an annuity is a promise by one party to make a series of payments of a specific value to another for a given period of time, or until a certain event occurs (such as the death of the person receiving the payments). As an actual investment, annuities are retirement vehicles by nature, tax-deferred financial contracts that are designed to accept and grow funds from an individual and then pay out a stream of payments to the beneficiary at a later point in time.

Annuities were originally created by life insurance companies to insure against superannuation, or the risk of outliving one's income stream. Modern annuity products can also help to pay for such things as disability and long-term care, and they can also serve as tax shelters for wealthy individuals whose incomes are too high to allow them to save money in other retirement vehicles such as Individual Retirement Accounts (IRAs).

The Parties Involved

There are four key parties involved in any annuity contract. They include the owner who pays the premium, the annuitant upon whose life the payout is calculated, the beneficiary who receives the payments and the insurance carrier that offers and maintains the contract.

The Phases of an Annuity Contract

The life of a modern annuity contract consists of three separate phases: accumulation, annuitization​ and payout. However, not all of these phases apply to all types of annuities. The specifics of each phase are broken down as follows:

Accumulation Phase
This is always the first phase in the life of any annuity contract. It is the period of growth for the annuity that begins after the initial payment is made. This phase will last until payments are scheduled to begin from the contract. In some cases, the investor continues to make regular additional payments into the annuity during this phase. Premiums can be paid in a single lump sum, a fixed series of payments or a flexible series of payments.

Annuitization Phase
Annuitization is actually a definitive event rather than a phase; it represents the point when the insurance company must begin making payments back to the investor.

Payout Phase 
The final phase of an annuity in which payments are made to the investor. This phase can consist of a single payment or a series of payments, depending upon what is chosen. When it comes to payouts, annuities can be either immediate, which means that they will begin paying out as soon as the premium is paid, or deferred, which will pay out at a later time. There are also several different methods of payout, such as single or joint life, life with period certain, interest only and systematic withdrawal.

Types of Annuities

There are three main types of annuities: fixed annuities, indexed annuities and variable annuities. Each carries a different level of risk and return. A fixed annuity is a type of contract that guarantees to return both the investor's principal plus a fixed rate of interest. These contracts essentially function much like Certificate of Deposits (CDs), except that they grow tax-deferred.

Indexed annuities are one of the newer offerings in the insurance marketplace. These contracts mirror fixed annuities in that they offer a guarantee of principal and a set term, but they do not pay a fixed rate. Indexed annuities, as the name implies, will invest in one of the major stock market indices, usually the S&P 500. The contract owner receives a share of the market's growth (if there is any), while avoiding any possible downside risk.

Variable annuities are the most complex type of annuity in the market today. In a nutshell, these contracts consist of a bundled offering of mutual fund sub accounts that grow under a tax-deferred umbrella.

Taxation of Annuities

Annuities are the only investment vehicle that grows tax-deferred outside of an IRA or company retirement plan. But like IRAs and qualified plans, annuities charge a 10% early withdrawal penalty for any distribution taken before age 59.5. Withdrawals taken after this age are taxed as ordinary income, regardless of the type of annuity or distribution. The only exception to this is when the contract is initially purchased inside a Roth IRA.

The Bottom Line

Annuities are fundamentally unique vehicles in many respects. They are the only retirement savings vehicle that offers unlimited tax-deferral, living and death benefit riders, money management programs (for variable contracts), protection from probate and creditors and the option of a guaranteed payout for life. However, these benefits come at a cost; annuities often charge high annual fees (as much as 3% in some cases) and are not very liquid. Many contracts have a back-end surrender charge schedule that can last for up to 15 years, with steep penalties being assessed for early withdrawals. Many of the riders that can be purchased require permanent surrender of control of the contract; but when they are used correctly, they can provide a kind of income protection that cannot be easily duplicated elsewhere.

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