What Is An Annuity?

Quick Answer: An annuity is a contract between you and an insurance company designed to provide a guaranteed income stream in retirement. You make a lump-sum payment or series of payments; in return, the insurer provides regular income that can last for a set period or for the rest of your life — the only financial vehicle that offers a contractual guarantee of lifetime income.

Today’s financial landscape is muddled. Determining the best investment options for your needs can be a hassle. Sound decision-making involves being financially educated. And for people looking at annuities, it helps to understand the basics.

What is an annuity? Simply put, an annuity is a contract between you and the insurance carrier providing it. The goal of an annuity is to provide you with a steady income stream in your retirement. It can also be a means of protection – keeping your retirement money safe and intact when market-based investments take a hit. In an annuity contract, you make a lump-sum payment or a series of payments. The annuity gives you certain contractual guarantees.

In exchange, you receive payments from the annuity beginning immediately or at some specific point within the future. These payments can be made at a future date or over a series of dates. In the case of a series of dates: these are paid out monthly, quarterly, or yearly. You can opt for an annuity offering payments for the rest of your life or for a set period of years in the future.

With these benefits, an annuity is the only financial vehicle which offers a guaranteed lifetime income. Except for SPIA/immediate annuities, most annuities have income tax deferral. As funds build up, they do so on a tax deferred basis, or they are shielded from taxation until they are withdrawn. According to government regulations, in most annuity contracts you can withdraw funds without penalty at 59.5 years of age. If you do choose to withdraw and incur the penalty, it is 10%.

What is an Annuity: Basic Terms

Now that we’ve covered some fundamental details, let’s look at the terms involved with annuities.

• Annuitization rate – The rate at which an annuity pays out.
• Annuity owner – The individual who purchases the annuity. They can change who the annuity beneficiary is and how much disbursement is. An annuity can have more than one owner, and a successor owner can be named as the new policy owner in the event of the existing owner’s death or incapacity.
• Annuitant – The person who is the insured. Oftentimes they are the policy owner as well. When disbursements are paid out, they are partially based on the annuitant’s remaining life expectancy. If they are older, their life expectancy is shorter, and the insurance carrier has a smaller window of time to distribute those payments.
• Beneficiary – The person to whom all the money in the annuity is left upon the annuitant’s death. The annuitant and the beneficiary cannot be the same person, but the owner and the beneficiary can. The owner determines the amount which each beneficiary earns.
• Surrender period – The period of time in which the majority of money must be kept in an annuity contract. The surrender period tends to last for 5-10 years, and most annuity contracts will allow for takeout of at least 10% of the account’s accumulated value. If more than 10% is withdrawn, a surrender charge, or penalty, will have to be paid on the amount withdrawn above the 10%. Oftentimes the surrender charges begins at 7% and over time drops to 0% by the end of the surrender period.
• Non-qualified & qualified annuities – A non-qualified annuity is a policy bought with money you have already paid taxes on. Qualified annuities are purchased with “pre-tax” money. Qualified annuities are often when someone purchases an annuity with an IRA or their work retirement plan, or transfer their 401(k) or 403(b) accounts into the annuity.
• Single premium & flexible premium annuities – With a single premium annuity, you pay the insurance carrier one lump sum. A flexible annuity option involves a series of multiple payments to the insurance carrier. There are two kinds of flexible annuity options. With a flexible premium contract, you are allowed to pay as much premium as you’d like, whenever you’d like, but within set limitations. And with a scheduled premium contract, your annuity contract provides details as to your payments and how often they are to be made.
• Fixed & variable annuities – A fixed annuity offers you a guaranteed payout, and a variable annuity and its payout stream is subject to the variable annuity’s underlying investments performance. In this case, the annuity puts your premiums into a separate account. You decide how they are invested and therefore how much risk to which they are subject.
• Fixed index annuity – A fixed annuity that is tied to an index, such as the S&P 500. If times are financially tough, the fixed index annuity will receive a minimum interest rate, such as at 1-2%. If the index records negative changes, your fixed index annuity contract will be credited zero, but the principal and prior-credited interest earnings stay intact. This is subject to the minimum guarantee set forward in the annuity contract. In periods of strong market performance, you can capitalize on a higher interest rate depending on the indexing strategy you choose. A fixed index annuity doesn’t have the risk which a variable annuity extends.
• Multi-year guarantee annuity – A fixed annuity in which you give the insurance carrier a specific amount of money. In exchange, the insurance carrier guarantees it will earn a defined rate of compound interest for a definitive number of years.
• SPIA/Immediate annuity – An annuity in which you are guaranteed an immediate fixed income for the rest of your life. In some instances, the income can continue for a certain time period after your death. In exchange, you are required to sign over all the money you deposit in the annuity to the insurance carrier. This is done with the understanding you are unable to do anything with it again, aside from receiving the monthly income.

Understanding the financial terms involved with any investment option you’re considering is essential. And once you’ve taken the time to do so, you’ve taken the first steps toward achieving retirement income security.

When you’re ready for personal guidance on planning for your future, meeting with a financial professional can help. We invite you to schedule a no-cost, no-obligation consultation to discuss your needs, goals, and overall financial picture.

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