Well of course, this question is too broad to have an answer that is both simple and comprehensive. The details of how an annuity works very much depend on the specific type of annuity that you are considering. In an effort to make you a more informed investor, lets first look at the basic concept of an annuity contract.
In general an annuity is an investment vehicle offered by a financial institution (usually an insurance company), into which one makes either a single lump sum payment or series of payments. In return the financial institution will make payments to you (the annuitant), beginning either immediately (called an immediate annuity) or beginning at some future date (called a deferred annuity).
Annuities offer the opportunity to guarantee an income stream, in some cases for the rest of your life. In essence they can work as an inverse life insurance policy. While a life insurance policy is designed to provide a benefit in the event that one does not live to their life expectancy, an annuity can provide protection in the event that you live longer than your life expectancy.
Types of Annuities:
In order to provide you with more information below is an overview of a few different types of annuities. These are meant to facilitate your ability to have an informed conversation with your insurance agent, broker, financial planner or other financial professional, when considering your investment options. Annuities come in a myriad of different types, and have different benefits, features and risks. Ask your financial professional for a prospectus on the annuities you are researching and consider the specifics of the particular annuity contracts that you are considering to determine whether or not they meet your investment needs.
Immediate Annuities: are those that begin to pay out immediately after funding.
Deferred Annuities: are those that do not begin to pay out until a future date.
Both immediate and deferred annuities can be broken down further into Fixed or Variable annuities.
Fixed Annuities: guarantee your principal and a rate of return while your account is invested. The financial institution offering the annuity contract manages the funds in a fixed annuity, generally investing these funds very conservatively. The payments from a fixed annuity are guaranteed to be a certain amount per dollar invested. The timeframe over which annuity payments occur can be a pre-defined period (for example 5, 10 or 15 years), or an open-ended period, generally your lifetime (or the lifetime of you and your spouse or other beneficiary in the case of a “joint and survivor annuity”). Fixed annuities are generally considered to be a low-risk investment option. Fixed annuities are the most popular type of annuity contract because they are such stable investment vehicles, especially in times of high volatility for other investment classes. It is important to fully research the fixed annuity contract that you are considering; fixed annuities may come with age restrictions, and penalties should you need to access your principal before maturity. Fixed annuities have many different variations, including; “equity-indexed annuities”, “life annuities”, “joint annuities”, “joint and survivor annuities”, and “life annuities certain”, to name just some of the options that are available.
Variable Annuities: allow you to invest your annuity assets among a range of investment options, rather than have the assets managed by the financial institution. A primary advantage of a variable annuity is that you can benefit from higher than expected performance of your investments. Conversely the primary drawback of a variable annuity is the principal risk and lack of certainty as to the amount of annuity payments that you will receive. Variable annuities carry higher risk than fixed annuities, based on the risk of the underlying investments, which are generally mutual funds (of equities, bonds, or money markets). Other features of variable annuities include tax deferral and death benefits. Variable annuities (and fixed annuities) are tax deferred investments, which means that you will not have to pay taxes on the investment gains of your annuity account until your receive payments from your variable annuity*. Variable annuities also carry a death benefit, which means that in the event of the annuity holder’s death before annuity payments begin your beneficiary will receive a death benefit payment. Typically the death benefit of a variable annuity is at least equal to the total annuity premiums paid less any withdrawals, even if the annuity account has lost value.
* It is important that you fully understand the tax-deferred nature of annuities when considering this feature. Funds withdrawn from a variable annuity (including normal periodic payments) are taxed at ordinary income tax rates, which will often exceed capital gains rates. The benefit of the tax-deferred nature of a variable annuity will likely only be realized if the annuity contract is a long-term investment. You may want to consult a tax advisor as well as your financial professional when considering these features.
While considering an annuity, remember that you will pay for the features and benefits of any annuity contract, as you would with any normal product or service purchase you make in your everyday life. Annuities will typically carry administrative fees, mortality and expense risk charges, and surrender charges. You will also likely incur the fees associated to the underlying investments in your annuity account (mutual fund expense fees as an example). Additionally withdrawals from your annuity account before the age of 59 ½ may result in a 10% federal tax penalty in addition to ordinarily applicable taxes on income and investment gains.