Annuity Contract: What it Means, How it Works

What Is an Annuity Contract?

An annuity contract is a written agreement between an insurance company and a customer outlining each party's obligations in an annuity agreement. Such a document will include the specific details of the contract, such as the structure of the annuity (variable or fixed); any penalties for early withdrawal; spousal and beneficiary provisions, such as a survivor clause and rate of spousal coverage; and more.

How an Annuity Contract Works

An annuity contract is a contractual obligation between as many as four parties. They are the issuer (usually an insurance company), the owner of the annuity, the annuitant, and the beneficiary. The owner is the person who buys an annuity. An annuitant is an individual whose life expectancy is used as for determining the amount and timing when benefits payments will start and cease.

In most cases, though not all, the owner and annuitant will be the same person. The beneficiary is the individual designated by the annuity owner who will receive any death benefit when the annuitant dies.

An annuity contract is beneficial to the individual investor in the sense that it legally binds the insurance company to provide a guaranteed periodic payment to the annuitant once the annuitant reaches retirement and requests commencement of payments. Essentially, it guarantees risk-free retirement income.

Annuity Contracts: What to Watch

Annuities can be complex, and annuity contracts may not be very helpful to many investors due to unfamiliar concepts and terminology. Keep in mind the following when shopping for an annuity:

• Be sure to understand what a surrender period is and how it is noted in an annuity contract. It is the period during which an annuity owner should be able to withdraw all their money without suffering a penalty.
• Keep an eye on multiple-tier contracts for withdrawing money. Tier 1 allows for withdrawals over a lifetime (or annuitization value—basically, an immediate annuity payout). Tier 2 may be enacted if the annuity owner wants to take out their entire balance as a lump sum, in which case the annuity seller may reduce the value of benefits by 10% or even 20%. The key is knowing if an annuity contract includes multiple tiers and what penalties may be triggered if the owner wants to liquidate their annuity.
• High teaser rates to encourage buyers followed by far lower rates for the life of the annuity contract. The way around this issue is to require the annuity seller to fully disclose the rate they will pay for the life of the annuity.
• Try to buy an annuity that allows a joint annuitant to be named, which gives owners and beneficiaries more flexibility with withdrawal timing and tax planning.

Annuity contracts have different withdrawal amount policies—make sure they are flexible. For example, most have a 10% withdrawal amount, but if you want to defer and instead withdraw 20% after two years, make sure that is an option without a penalty (known as cumulative withdrawals).