Annuity Definition

At its most basic, an annuity is a contract between an investor and an insurance company. The investor gives the insurance company either a lump-sum premium, which is also known as a single premium, or he or she provides multiple premiums over time. The time during which he or she makes multiple payments is called the accumulation phase. In exchange for the premiums, the annuity owner receives payouts for life that are guaranteed. This is called the distribution phase. The payouts are distributed monthly, quarterly or annually, depending on the choice made by the annuity owner. The start date and the amount of the payouts depend on the kind of contract.

An annuity can be fixed, variable or indexed. These can be either immediate or deferred. The kind of annuity that is right for an investor depends on several factors, including the number of years before retirement, the amount of income that he or she will receive from other sources and the other assets such as savings accounts, equities and real estate.

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The Fixed, Variable and Indexed Annuity Definition

The premium for each type of annuity is invested in the equity or bond markets or a combination of the two. However, the risks incurred by each kind of annuity are different.

Fixed annuities pay a set return, regardless of fluctuations in domestic and foreign stock, bond and credit markets. The premium paid by the investor to the insurance company is invested in very conservative mutual bond funds. The bond funds typically own United States Treasuries. They may also include highly rated state and municipal bonds, along with low-risk corporate bonds. Some insurance companies will offer a guaranteed fixed return anywhere between 2% and 6% of the total principal. While this seems like an advantage when yields on treasuries are low, it may not be enough to beat inflationary pressures that will erode an investor's purchasing power.

The returns paid on a variable annuity depend on how an investor decides to invest the premium. He or she can usually choose from a number of different mutual fund types, from very conservative or very aggressive funds, or he or she can choose a combination of the two, depending on his or her tolerance for risk. As with almost all other financial products, higher reward potential usually means taking on more risk. For those investors interested in variable annuities, awareness that principal could be lost in market downturns should always be known. But, it’s also possible that the annuity account can grow more quickly than other types of investments.

An indexed annuity is tied to a market index, most commonly the Standard and Poor’s 500. The S&P 500 is the broadest of the markets and measures the 500 largest companies by equity capitalization. Because it is large and broad, an S&P 500 indexed annuity spreads the risk of loss over all market sectors. The premium paid for an indexed annuity is put in an index fund.

The returns are then based on the performance of the entire index. In other words, while stocks in the “Consumer Discretionary” sector might be lower, those in another category may have risen. An investor in an indexed annuity should always be prepared to take a loss, as the loss of principal might occur with a market downturn. Further, almost all insurance companies will cap the maximum amount that they will pay as part of the payout. If the cap is 7%, only 7% will be paid out even if the S & P 500 increases by 9% during the year.

Fixed annuities are usually sold as immediate annuities. This means that the payouts begin within 12 months of the contract start date. Immediate annuities are also typically bought with after-tax dollars from a checking account, the death benefit of an insurance policy or with the money made on the sale of property. An indexed or variable annuity can also be an immediate annuity, but these are usually deferred annuities.

Deferred annuities are those for which the taxes and distributions are deferred, usually until after retirement. A deferred annuity can be part of an employer sponsored defined contribution plan like a 401(k) or it can be bought by an individual. A deferred annuity is a good way for those who have maxed out their qualified plans to save more money for retirement.

Annuity Definition and Financial Needs

The biggest financial need that is met by an annuity is a guaranteed stream of income after retirement. As Americans live longer and face increases in health care expenses, they risk outliving their retirement savings. Because all annuities grow tax-deferred, it means that the interest credited to the account accumulates faster because none of it is deducted to pay taxes. Once distributions begin, the earnings are subject to taxation. However, the amount of the payout that represents a return of the premium is not subject to being taxed. Therefore, annuities enjoy a special tax status that is far better than other types of investments.

What Type of Investor is Best Suited for Annuities?

Most insurance companies offer a “free look” period during which an annuity investor can decide to cancel the contract without penalty. However, once the contract is signed, it cannot be cancelled. The premium cannot be returned except in the form of payouts in accordance with the contract. An annuity is best suited for an investor who will be able to keep enough cash to meet financial needs not be covered by the annuity payouts. Financial advisors, both those who are independent brokers and those who work for insurance companies, often advise an investor to make sure that he or she has at least $25,000 to $50,000 in liquid cash reserves after funding the immediate annuity.

Aside from those who want an annuity as part of a retirement savings plan, professionals who are subject to being sued often are sometimes urged to purchase annuities. Most states consider annuities as irrevocable contracts.
