A Basic Understanding of the Annuity

Quite often, we see the word “annuity,” but what is it? In simplest terms, an annuity is a savings vehicle that can be used to supply a lifetime income in the future. Most often, an annuity is purchased by someone who is currently working and wants to put away money for retirement, a retiree that desires a stream of income in a specified amount or over a number of years (e.g. 5 years or lifetime), within the immediate future (i.e. less than one year) , or as payment due from a legal settlement.

Just as one can use a bank savings account or open a non-qualified brokerage account to buy stocks or mutual funds in order to invest for retirement, an annuity can serve a similar purpose. But unlike a savings account and/or the non-qualified brokerage account mentioned above, an annuity’s earnings can grow on a tax deferred basis, which means that you would not pay taxes until the money is withdrawn, in most instances. In addition, you will not receive a 1099 tax form from the annuity insurer each year, provided that there are no withdraws from the account; however, this would not be the case if you earn interest from a savings account, or the stock or mutual fund that you own declares and pays a dividend in a given tax year, regardless if you received the payment in the form of a check or left the earnings on deposit with the bank or brokerage firm.

Under certain circumstances, you would not be required to pay any taxes on withdraws from an Annuity Roth IRA, but you must meet the age requirement and the account must be opened for a specified number of years. As always, please consult a tax accountant or other financial or legal professional for more details.

The fixed annuity is a popular product of individuals over the age of 65. Unlike some of the other types of annuities that will be discussed, the owner of the traditional fixed annuity policy knows in advance how much interest will be earned in a given tax year. For example, if the policy states the owner will earn 5% for 2008, then this amount of earnings will be credited at the end of the policy year. The fixed annuity is backed by the financial strength of the fixed annuity issuer. Therefore, the annuity insurer is left with the responsibility of paying the interest to the policyholder regardless of the company’s investment earnings in a given year.

Like a Bank Certificate of Deposit (CD), the fixed annuity can be extremely attractive in down markets, when individuals are less likely to take substantial financial risk, but these individuals could expose themselves to inflation risk and interest rate risk. Inflation risk occurs when the cost of items and services increase in price; therefore, the value of your purchasing dollar is decreased. On the other hand, interest rate risk will become a concern when an individual is able to earn a higher rate of interest elsewhere, but the surrender charges of the annuity product prevent the person from moving to another higher interest paying annuity or other financial products such as a money market or bond.

The variable annuity is both an annuity and considered a security. Because of this reason, variable annuities are regulated by both state and federal regulations. The annuity issuer allows the purchaser to choose from a variety of investment subaccounts. Unlike a fixed annuity, the various subaccounts of a variable annuity can gain or lose value, depending on the performance of the underlying subaccounts with the exception of the fixed subaccount that earns a fixed rate of return.

*****In part 2 of this article, there will be an examination of other annuity products including the equity indexed annuity and market value adjusted annuity (MVA).