Annuity Basics

Parties to an Annuity Contract 
When you invest in an annuity, you enter a contract with an insurance company under which, in return for your investment, the insurer promises you (and/or your heirs) a stream of payments starting now or in the future. 

Fixed vs. Variable 
The focus is on the underlying investments. Fixed annuities are invested primarily in bonds, bond funds or the insurer’s general account. Variable annuities are invested primarily in stocks, stock funds or stock index funds. 

Immediate vs. Deferred Annuities 
The focus is on when payouts begin. With an immediate annuity, the insurer agrees to start making payments soon after the contract is signed. With a deferred annuity, payments by the insurer are postponed until a later time. 

The Four Basic Types of Annuities 
Combining the immediate, deferred, fixed and variable options creates the four basic types of annuities: 

Immediate Annuity - Fixed: You lock in an earnings rate, and receive monthly payments that include a return of your investment plus taxable earnings. The amount of the monthly payment will depend on the options you choose and your age. Comment: In some cases, these are effectively used by people who want the assurance of payments that they cannot outlive. 

Immediate Annuity - Variable: Monthly payments will vary according to how investments in the stock market perform. There is no guaranteed monthly payment amount. Comment: Has greater risk than an Immediate Annuity - Fixed. 

Deferred Annuity - Fixed: Locks in a fixed rate investment approach (although guarantee periods vary), with delayed pay-out. Comment: In addition to the underlying investment risk, the risk is that the return will not beat inflation. 

Deferred Annuity - Variable: Provides tax-deferral and potential for growth in value. Comment: Can be suitable for those who have “maxed out” their annual contributions to other tax-deferral tools [e.g., IRAs and 401(k)s] and can wait for stocks to outperform other types of investments over the long-term. 

The Underlying Investment 
An annuity is an investment product that has an insurance policy packaged with it. The investment portion allows you to spread your money among one or more funds (called sub-accounts); or, in the case of a fixed annuity, your money may be invested by the insurer through its general account. 

Payout Options 
Many different payout options are offered by insurers. Common structures provide for payments either for (1) the rest of your life, or (2) as long as you or your spouse is alive, or (3) a set period (such as 10 years). The annuity payments are usually monthly. 

Surrender Charges 
Most deferred annuities have surrender charges (a penalty you must pay to withdraw principal before a specified date). Surrender charge provisions often allow annual withdrawals of 10% of principal per year without a penalty. 

Annuitizing a Deferred Annuity 
When you begin taking payments from an annuity, you have “annuitized” it. The vast majority of deferred annuities are never annuitized. As a result, the earnings are not paid out during the owner’s lifetime, and the income tax liability passes to the heirs (who may be in a different income tax bracket). 

The Insurance Feature 
The insurance feature in a variable annuity promises that if you die, your heirs will receive at least the premiums you’ve paid into the account (or in some cases an enhanced death benefit). A part of the expense built into the variable annuity is the cost of the insurance feature. Note: Independent studies report that this insurance coverage is often either worthless (because the account value is high enough that the insurance doesn’t apply) or much more expensive than if it were purchased separately. 

Advantages 
The chief benefit of a deferred annuity is its tax-deferral. Funds left in the annuity are not taxed until they are withdrawn. When withdrawn, they will be taxed at ordinary tax rates. The chief benefit of an immediate annuity is locking in a monthly income stream. 

Drawbacks 
Among the disadvantages of deferred annuities can be high expenses (almost 1% more a year than mutual funds), high surrender charges during the initial years of a contract, and the tax burden they can impose on heirs. With fixed annuities (deferred or immediate) inflation can eat away at the value of the locked-in fixed payments.

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This is Part 2 of the Special Report - go to Part 3.