Understanding Annuities

Understanding Annuities
Annuities attract a great deal of attention as tax-deferred investments. The subject of saving taxes is always popular. However, no other investment vehicle seems to generate controversy among financial planners as does the topic of annuities. Some investment advisors view annuities as a “great addition” to a portfolio while others argue that annuities are simply not worth the high management fees and commissions, and that investors should consider other investment vehicles which might be more suitable from the standpoint of tax savings. A few financial advisors will go even further, and state that annuities really only benefit the annuity salesperson! No one investment can ever be right for everyone. It is true that all too often uninformed individuals will purchase an annuity only to later find out that the annuity returns have been diminished by excessively high management fees or that it was an inappropriate investment based on their financial objectives. Some people are not aware that annuities are long-term investments, and that if an annuity is terminated, taxes and additional fees will have to be paid. If an individual decides to terminate an annuity, a 10% early withdrawal fee will also be assessed on the account.

Some of the questions that people commonly ask about annuities include:

What is the definition of an annuity?

An annuity is defined as a contract between an insurance company and an individual, more often than not, for the purpose of retirement income. The investor, who in this scenario, is defined as the annuitant, contributes the money either in the form of a lump sum or in a series of periodic payments.

What are the types of annuities?

There is almost a seemingly endless variety of annuities. However, the most well known are fixed, variable, and combination. Other types of annuities include the charitable gift annuity and equity-indexed annuity.

The fixed annuity option guarantees a minimum rate of return. However, when the annuitant decides to receive income, the payout is determined by two critical factors such as the account's value as well as the annuitant's life expectancy based on mortality statistics. It is also important to note that the fixed annuity is subject to the risk of inflation and the cost of living but that the fixed payment option remains a permanent feature throughout the annuitant’s life span.

A variable annuity which involves more risk because it is invested in the stock market may have a better chance of keeping up with inflation than a fixed-income annuity (at least that is the hope!). Any money invested in equities always has the potential of risk. However, the payout from the variable annuity will vary because the value of the account will fluctuate with the stock market's overall value. Furthermore, the financial contribution an investor makes to the variable annuity account is held in an account that is separate from the account of the insurance company’s general funds. Special Note: it is the investor who bears the investment risk and not the insurance company. Every variable annuity must be registered under the Investment Company Act of 1940. Salespersons of variable annuities must be registered with the SEC and NASD as well as be licensed by state departments of insurance.

A combination annuity has the features of both a fixed and variable annuity. Often referred to as a “hybrid annuity, the combination annuity offers a certain degree of versatility in payment options. The investor makes financial contributions to the fixed account and the variable account.

What about sales charges on annuities?

The sales charge cannot exceed 8.5% of the total payments.

What types of other fees or charges are associated with annuities?

Annuities can incur a variety of fees such as an annual expense fee, contingent deferred sales charge, surrender charge, commission, as well as an administration fee.

What are the payment options?

Although there are many payment options, the most common are straight life, life annuity with period certain and joint life with last survivor.

Straight life: This type of annuity provides a periodic payment for the lifetime of the annuitant.

Life annuity with period certain: An annuitant receives payment for his or her lifetime with a minimum number of payments guaranteed for a specified period of time such as 10 years or 15 years, for example.

Joint life with last survivor: This annuity guarantees a payment for the entire lifetime of one or more individuals. Upon death of one of the beneficiaries, payments will still be made to the surviving beneficiary.

How are annuities taxed?

As annuities are tax-deferred investments, the interest, dividends, and capital gains cannot be taxed until the annuitant withdraws the money. The money that exceeds the cost basis of the investment is taxed as ordinary income.


Clearly, annuities are complex investment vehicles, and require specialized knowledge of actuarial science, taxation, and investment management. This is only brief exploration of the most basic aspects of investing in annuities. Hopefully, it will encourage people to explore this topic further by reading more articles and books.

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