An annuity is a contract between you and an insurance company whereby you agree to give the issuer principal and in return the issuer guarantees* you fixed or variable income payments over time. While annuities are not insurance policies, they are issued by insurance companies.
Annuities are long-term, tax-deferred investments intended for retirement planning. You can fund it in a lump sum or a little at a time, and all capital in an annuity grows and compounds tax-deferred until you begin making withdrawals. (Withdrawals of earnings or other taxable amounts are subject to income tax and, if made prior to age 59½, may be subject to an additional 10% federal penalty tax. Early withdrawals have the effect of reducing the death benefit and contract value.) Unlike retirement plans, however, there is no limit as to how much you can invest in annuities (unless it is a qualified plan), and you generally do not have to begin withdrawals until at least age 85 (unless it is a qualified plan).
The large number of annuity products on the market today can make selecting the right annuity a confusing process. But in fact, there are only a handful of different types of annuities. When selecting an annuity, you will be presented with several choices:
Timing of payout—immediate or deferred: In an immediate annuity, the investor begins to receive payments immediately. This is usually for investors who need immediate income. In a deferred annuity, the investor receives payments starting at some later date, usually at retirement.
Investment type—fixed or variable: Fixed annuities are invested primarily in government securities and high-grade corporate bonds. They offer a guaranteed* rate over a period of one or more years, as stated on the contract. Variable annuities enable you to invest in a selection of sub-accounts. These sub-accounts are tied to market performance and are therefore subject to investment risk (unlike fixed annuities), and are often modeled after publicly traded mutual funds.
In addition, annuities can be (1) "single premium," meaning only an initial deposit is permitted into the contract, and any additional deposits would require a new contract, or (2) "flexible premium," which permits periodic or regularly-scheduled additions, including automatic withdrawals from a bank account. Variable annuities are almost always structured as flexible premium annuities.
Variable annuities have the potential to make your money grow by participating in the stock market. Your money accumulates tax-deferred in professionally managed sub-accounts. Historically (past performance is no guarantee of future results), a variable annuity invested in a stock sub-account over the long term provides better protection against inflation than a fixed annuity, but also involves a greater degree of risk. Variable annuities are considered securities under federal law, and can be offered only by agents who are licensed and who have passed specific securities exams.
Variable annuities provide many of the benefits of fixed annuities—including tax-deferred earnings and a choice of payouts, plus the opportunity to make unlimited contributions if the annuity is not part of an IRA or qualified retirement plan. In addition, they offer the potential for greater returns and the opportunity to make your own decisions about how to allocate your assets among investment categories. Variable annuities allow you to use strategies like dollar-cost averaging, and some even offer automatic portfolio rebalancing to maintain your preferred level of risk.
With variable annuities, many things can vary or change: the rate of return that you earn, the amount of income you receive if you annuitize (take a guaranteed lifetime or term-certain payout), and how your money is invested. What remains constant with all annuities, fixed or variable, is the opportunity to select income guaranteed* to last for your lifetime.
Deferred variable annuities differ from fixed annuities in another important way. Your retirement savings go into individual "sub-accounts" held by the issuer separately from its other assets, rather than into its "general" account (except for any money you put in a fixed account option).
Your money in these individual sub-accounts is invested in the investment portfolios you choose. As a result, your retirement savings in these accounts are shielded from the issuing company's creditors. Some states protect your savings from your creditors as well. However, these funds are subject to investment risk, and both income and principal can and will fluctuate.
Deferred annuities feature an accumulation phase, during which funds may be invested and balances grow tax-deferred, and a payout phase, when the funds are distributed.
Immediate annuities, as noted above, are appropriate for investors who need to begin receiving their income immediately, and want a dependable stream of regular income.
With a variable annuity, when the owner annuitizes and chooses the form of payout, the payments can be either fixed or variable (depending on account performance during the payout period). Choices include a lifetime income, or a different term can be chosen if preferred. For example, using a ten-year "term certain" payout would usually result in larger periodic payments, but the payments would end after ten years. Other choices that impact the payout amount include whether the payout will cover two people (until the death of the survivor), and whether the amount paid will be reduced after the first death, if two people are covered. These are choices that need not be made until it is time to begin the payout phase, which can usually be deferred until at least age 85 (unless it's a qualified plan). You can also make earlier periodic withdrawals without annuitizing (subject to early withdrawal penalties and surrender charges, if any).
It is very important to understand that once the decision is made to annuitize, you are relinquishing control of your money to the insurance company. Generally, in exchange for the company's promise to pay you income based on the option you have chosen, you can no longer withdraw lump sums or change your payout schedule.
*Guarantees are backed by the claims paying ability of the issuing insurance company.