What Is An Annuity?

Annuities are insurance products designed to help you invest for retirement and provide supplemental income during your retirement. The most common form of annuity is income annuity where the investor pays the insurance a sum of money in exchange for a series of regular payment for a period of time, up to a lifetime contract.

What are the different types of annuities?

There are two categories of annuities and each has two types:

Types of Annuities

Deferred Annuity

Deferred annuity allows you to invest for retirement on a tax deferred basis, while delaying payments of income. This allows you to contribute to your savings and let it grows faster without the burden of taxes. There are two types of deferred annuity:

Deferred fixed annuity allows you to save money while your investment grows with a guaranteed rate of returns.
Deferred variable annuity allows you to save money, but the performance fluctuate based on the performance of the underlying investments. This type of annuity provides you with a potential to earn superior returns.

Once you are ready to retire, you can convert your deferred annuity into an income annuity (also known as immediate income annuity or immediate annuity), which will provide you with a source of guaranteed lifetime income.

Some points to consider regarding deferred annuity:

You should make the maximum allowable contributions to traditional retirement savings plan such as 401k and IRA before considering a deferred annuity.
The IRS does not limit the amount you can contribute to a deferred annuity.
Some annuities come with additional options, however you should consider the cost versus benefits when buying these options.
Just like any other investment, high expenses will reduce your overall performance and long-term results.
Be aware that if you withdraw your money too soon, you could be hit with big surrender charges.
Like 401k and traditional IRA, you don’t have to pay taxes until you start the distribution.
Taxable amount is taxed as ordinary income.
Distributions made prior to age 59 and a half may be subject to a 10% IRS penalty.

Income Annuity

Income annuity allows you to convert a portion of your retirement savings, such as part of your 401k, IRA, and deferred annuity in to a source of guaranteed lifetime income stream. Essentially, you are giving the insurance company a lump sum in exchange for a stream of income until the day you die. There are two types of income annuity:

Fixed income annuity provides you with a guaranteed lifetime payments regardless of the stock market and the economy. Some annuity will increase payment by a certain percentage to give you a level of inflation protection.
Variable income annuity also provides you with a guaranteed lifetime payments. However, the amount will vary depending on the performance of the annuity. This type of income annuity has the potential to provide you with greater income compared to fixed income annuity.

Some points to consider regarding income annuity:

Income annuity reduces the uncertainty of outliving your assets.
It gives you a level of confidence to work with, or withdraw from, your remaining retirement savings.
Payments from income annuity could work in conjunction with other sources, such as Social Security and pension to cover essential living expenses.

A Personal Perspective

Annuity may sound appealing, but remember that insurance companies are in the business of making money…a lot of it. In essence, you are playing the game of probability that favors the insurance company most of the time. However, I think annuities have their places and could be the right choice for some individuals.

Here are more articles about annuity:

A Look at an Equity-Indexed Annuity at All Financial Matters
The Financial Freedom Ratio: A Better Way To Measure Your Net Worth? at My Money Blog
Be Careful When Your Financial Advisors Tries To Sell You An Annuity at My Investing Blog
Lies Annuity Salesmen Tell: A Dateline Undercover Investigation at Consumerism Commentary

6 Comments

B Smith @ Wealth and Wisdom
May 13, 2008, 6:37

I am sure that annuities are a good idea for some people, especially as you near retirement who need consistent income. I think that for most people they are not a good deal. Remember, the insurance company needs to make a profit. They make a killing on annuities. You can do better with other income streams.
I also think that most annuities get a bad rap because of how they are sold. 99% of the people below 55 should never own one. They should also never be put into a retirement account. They are already tax deferred.
I do know people that have them purchased as part of their estate planning. In this case they serve the purpose of giving their beneficiaries a consistent income stream.
hank
May 13, 2008, 9:15

@ B Smith – I agree that nobody under 55 should have one, and yes, they DO fill a niche for some people. I’d be very hesitant to buy one if I wasn’t maxing out all of my other retirement accounts.
Sure, people are buying them, but just because it CAN be sold, doesn’t mean it SHOULD be sold. They are likely being sold to you by the same folks that have tried to get you to buy their universal life insurance, so beware on that front.
Do your homework on them and make sure you hit some basic criteria before even considering to buy one.
Make Friends, Earn Money
May 13, 2008, 11:59

Pinyo this is a really clear and concise summary of a difficult subject. Especially liked the flow chart at the start it really makes it so much easier to understand.
imDavidLee
May 13, 2008, 17:55

any insurance company also have this kind of annuity?
cg monster
May 13, 2008, 18:35

It seems annuities are something to use with a lot of caution, check out Money-Guy’s excellent podcast and blog entry on this topic: The Price of Security – Immediate Annuities
hank
May 13, 2008, 20:05

@imDavidLee – I’d say that most do. It’s a branch off insurance companies, so if you’re so inclined, I’m sure you could ask any life insurance salesman and they’d give you the info you’re looking for…