What Is An Annuity?

What Is An Annuity?

A lot of people ask the question, what is an annuity or what are annuities? The problem is most annuity definitions refer only to immediate annuities and are very limited in their scope to things like:

– a fixed sum of money paid to the owner each year, usually for the rest of their life.
– an insurance contract guaranteeing the owner a series of annual payments.
– the process of giving an insurance company a lump sum of money and the insurance company guarantees you an annual payment back for the rest of the annuitant’s life.

Annuity Definition

While these definitions are accurate, they are only referring to immediate annuities. There are also deferred annuities which can be a wonderful alternative to an immediate annuity. The most accurate definition of an annuity is: a contract between you and an insurance company stating you will pay for the annuity in either multiple payments over time or a single lump sum. In return, the insurance company promises to make payments from the annuity to you in a series of payments or a single lump sum. An issue of concern today in regards to purchasing immediate annuities is the fixed sum of money paid out each year are at all-time lows. The annuity formula for immediate annuity rates is tied to current interest rates and insurance companies back the product buy purchasing government bonds. This could potentially leave the owner of the annuity with a retirement income stream inadequate for inflation. At the end of the day all that matters is what you give the insurance company and what they guarantee they will give you back. If you really want to do the math yourself and are good at equations here is an example of an annuity formula:

what is annuity

Another option to consider is a deferred annuity because a deferred annuity could increase in value for a period of time with the benefit of being annuitized or ten-thirty five (1035) exchanged to an immediate annuity. Furthermore, deferred annuities have lifetime income riders which also guarantee an income stream when activated and some products have increasing income features to help with inflation.

Most annuities sold today are actually deferred annuities which DO NOT require the owner to annuitize the lump sum of money given to the insurance company and the gains are not taxed until withdrawn. This is extremely important because people can actually take withdrawals from a deferred annuity (typically up to 10% per year without incurring a surrender charge), still earn good interest on their principal and leave whatever balance is left to their beneficiary(s). Keep in mind that non-qualified annuities are what’s call LIFO, which means “last in first out” when it comes to taxation. This means gains will be taxed as ordinary income before the owner dips into the principal at which time they would pay no tax because the basis (amount put into the annuity) has already been taxed. Deferred annuities also allow for the owner of the annuity to switch to another financial vehicle in the future, but it is wise for the owner of the annuity to wait until the end of the surrender charge period so they can transfer the entire amount and not incur a penalty. Also if the owner is unhappy with the performance of the annuity or just wants to move the money into something else they can do so without incurring any penalties if they wait until the end of the surrender charge period. The surrender charge schedule allows the insurance company to plan accordingly with their general account (which backs the product) in a similar fashion to banks which sell CD’s. The advantage to annuities over CD’s are the interest rates people get with insurance companies are usually higher. With a lot of annuities they do not charge a management fee which can be appealing for people who don’t see the value of paying fees to a money manager. Unfortunately the information readily available about annuities is more about providing a stream of income during retirement which leaves deferred annuities in the back seat and unexplored.

It seems annuities are a very controversial topic and a lot of people have opinions on them, most likely because of the fees and crafty sales tactics used by some people who sell them. A great deal of advisors swear by annuities and say a diversified retirement portfolio is essential, and annuities can add balance, giving people peace of mind. On the contrary other advisors are convinced annuities were created by the devil and people should put their money into stocks, bonds, and mutual funds. It is wise to get the facts and take the time to decide for yourself if and what annuity might be appropriate, after all it is your money. Compare multiple products with various insurance companies and make an educated decision based on what annuity might be best for you. Analyze the cost of the annuity, whether that be fees, caps, spreads or interest rates, and make sure your expectations match up with the product you are purchasing. Most of the negative information about annuities comes from people who did not ask enough questions and did not fully understand the product they were buying.