Annuities

What Are Annuities?

An annuity is one of the most versatile tools for building a retirement fund.

Simply put, it’s a personalized contract between the purchaser, or annuitant, and the issuing insurance company. The terms, provisions and payouts are specific to each customer.

Since annuities can be tailored to individual needs, preferences, and financial goals, there are complex differences from one type to the next. With a little education, though, you’ll appreciate the flexibility and earning potential that annuities offer.

How Do Annuities Work?

Annuities are designed to provide an income stream either immediately or in the future. The premiums are outlined in the contract, and payouts are calculated based on interest rate risk. Riders with various benefits are often attached.

As with 401(k)s and IRAs, there are significant tax advantages. If you fund an annuity with money that has already been taxed, only your earnings will be taxed when payouts begin. Unlike other retirement plans, there are no limits on how much you can contribute.

Best of all, the risk of outliving your retirement savings — known as longevity risk — shifts to your insurance company.

Types of Annuities

Fixed, variable and indexed are the most basic options. The best choice for you depends largely on how much risk you’re willing to assume:

• Fixed annuity

This type has a predetermined interest rate that remains the same, in most cases, for the duration of the contract. If the interest rate is scheduled to reset on certain anniversaries, you’ll know up front.

The investment always pays the same reward no matter how the stock market is faring, so a fixed annuity is considered low risk. The fees and commissions are very affordable.

• Variable annuity

This version is much riskier. The interest rate is linked to your entire investment portfolio. Earnings are unpredictable and depend on the health of your portfolio.

However, if you’re willing to take on greater risk, the variable type could pay off handsomely.

• Indexed annuity

This type is also known as equity indexed or fixed indexed. On the risk scale, it’s somewhere in the middle. The S&P 500, the Dow Jones, or another stock index determines the interest earnings, but there’s a guaranteed minimum rate of return.

Payout Options

You can opt to start receiving payments almost immediately or at a date far in the future:

• The immediate income, fixed-period structure is favored by people who suddenly find themselves wealthy. If you won the lottery, for instance, you might buy a fixed-period annuity to ensure that you don’t blow through your winnings. The guaranteed monthly payments, typically spread over a period of 10 to 30 years, would begin quickly.

• With the deferred income plan, payments typically start at a certain age or upon retirement. The investment has years to grow on a tax-deferred basis.

You have even more choices in annuities:

• In a life-only contract, only the annuity owner can receive payments. Payments cease upon death even if there is time left on a fixed-period contract.

• For a lump sum, you can purchase a joint and survivor lifetime annuity. This annuity also covers your surviving spouse in the event of your death. Some contracts are structured to provide for a third beneficiary.