In a fixed annuity, the insurance company agrees to pay you no less than a specified rate of interest during the time that your account is growing. The insurance company also agrees that the periodic payments will be a specified dollar amount in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.
In an indexed annuity, the insurance company credits you with a return that is based on changes in an index, such as the S&P 500 Composite Stock Price Index. Indexed annuity contracts also provide that the contract value will be no less than a specified minimum, regardless of index performance.
In a variable annuity, you can choose to invest your purchase payments from among a range of different investment options, typically mutual funds. The rate of return on your purchase payments, and the amount of the periodic payments you eventually receive, will vary depending on the performance of the investment options you have selected. This sounds like simply investing in mutual funds themselves, but there are some key differences. First, the payments you receive will often be for the rest of your life or life of a spouse. Second, there is typically a death benefit of a minimum amount, usually equal to at least the principal you have paid. This means a minimum return at death if payments have not yet started no matter what the markets are doing. Third, they are tax-deferred resulting in tax only being paid on the payments you receive.
Due to the many varieties of annuity products, determining whether an annuity is the right choice for you largely depends on your personal circumstances and risk tolerance. For example, an income, or fixed, annuity can guarantee income for your remaining lifetime with a set interest rate for growth and fixed monthly distribution amounts. Someone in good health with a low risk tolerance may choose to purchase such an annuity if worried about outliving his or her retirement savings. This option also requires that the person have sufficient savings to purchase the annuity without needing access to that money for other unforeseen emergencies.
There are a couple of main expenses to be aware of before purchasing an annuity.
Annuities have a reputation of carrying higher fees than a typical investment. This is partially to compensate for some of the guarantees that may be included as part of the annuity. A variable annuity may have more features, often resulting in slightly higher fees than a fixed annuity. For example, the underlying mutual fund in which the funds are invested may carry a management fee typical for any managed mutual fund.
Additional fees often include a mortality and expense charge. This fee pays for the insurance guarantee, commissions, selling, and administrative expenses of the annuity contract. The mortality and expense charge in a variable annuity is charged as a percentage of the average value of the investment.
Another applicable fee is the surrender charge. This is to keep you from withdrawing the funds too early. This fee typically decreases as time goes by and even may reach zero once the investment has been there long enough. This fee supports the idea that annuities should typically be purchased as a long-term investment.
The last fee worth mentioning is the sales commission that typically goes to the advisor or sales person for selling the annuity to the client. These are often part of the price of the annuity but obviously are used for compensation purposes. There are some no-load annuities that are sold directly to the client from the insurance company for which there is no commission and possibly no surrender charge.
If an annuity is used in a qualified pension plan or an IRA, then all of the annuity payment is taxable as current income upon distribution (because the taxpayer has no tax basis in any of the money in the annuity). If the annuity contract is purchased with after-tax dollars, then the contract holder upon annuitization recovers his basis pro-rata in the ratio of basis divided by the expected value, according to the tax regulation Section 1.72-5. (This is commonly referred to as the exclusion ratio.) After the taxpayer has recovered all of his basis, then all of the payments thereafter are subject to ordinary income tax. In other words, the after-tax principal invested is not taxed while any income distributed above the principal amount is taxed as ordinary income. The exclusion ratio determines how much of each payment is considered principal being returned and how much is considered income. Once the principal has all been distributed then all of the subsequent payments are fully taxable. This is something to remember as the tax owed will increase with time and when the principal is all returned.
One site that has a lot of resources regarding annuities is AllThingsAnnuities.com. (This is not an endorsement of this website.)
Vanguard, a leader in low-cost investment options, also has information about annuities.
Definitions provided by the Securities and Exchange Commission: