What is an Annuity?

An annuity is a contract between an investor and an insurance company or other approved company. The investor makes a payment or series of payments to the insurer. In return, the insurance company makes scheduled income payments back to the investor. Similar to bank CDs, insurance companies offer different types of annuities with different rates and returns on the investments.

The most common forms of annuities are: fixed, variable, and equity-indexed annuities. Each annuity provides two basic options: an immediate or deferred payment; and a fixed or variable return. An annuity with an immediate payout begins payments to the investor beginning right after the purchase, while a deferred payout provides payments at a later date(s).

With an immediate annuity, the investor pays for the entire annuity with a single payment. The annuity begins making regular, scheduled payments immediately. The most common use for an immediate annuity is to provide a guaranteed income for a retiree that is not susceptible to market risk. The investor simply takes all of the money saved for retirement and invests it in the annuity all at once.

The deferred payment annuity is a combination of retirement savings and retirement payment plan where the investor makes regular contributions to the annuity until a certain date and then receives regular payments from the annuity until death. Sometimes there is a life insurance component added so that if the investor dies before annuity payments begin, a beneficiary gets either a lump sum or the scheduled annuity payments.

A fixed annuity provides a fixed, contracted return on the initial payment by investing the money in low-risk securities such as government bonds. A variable annuity provides returns on the initial investment that vary with the performance of the funds where the insurance company invests the money, for example in stocks.

An equity-indexed annuity is a special type of annuity tied to a specific stock index. During the accumulation period - the lump sum payment or series of payments - the insurance company credits the investor with a return based upon changes in an equity index, such as the S&P 500. The insurance company typically guarantees a minimum return. Guaranteed minimum return rates vary. After the accumulation period, the insurance company makes periodic payments or a lump sum payment to the investor, depending on the terms of the contract.

Annuities have some excellent advantages over other investment vehicles. Some benefits include:

- guaranteed principal and interest payment

- tax-deferred savings growth

- additional retirement account investment

- avoidance of probate for estate upon death

- increased death benefit

- stock-market linked gains without downside risk

- inheritance investment benefits

The majority of investors saving and planning for the long-haul do not really need an annuity's return guarantees. These guarantees protect against market downturns, but if the investor is truly focused on the long-term, history dictates that the market will remain positive over the long-term.

Approach variable annuities with caution. This type of annuity invests in sub-accounts, generally mutual funds and other investment vehicles, and their costs and fees are passed on to the annuity contract, usually 0.5% to 1.25% annually. The investor also must pay for the insurance component, called mortality and expense risk charge (M&E). The average annual M&E charge is 1.15%. These charges can create a significant drag on a variable annuity's return.

Annuities also incorporate stiff surrender charges. If an investor withdraws money from an annuity early, the surrender charges can be as high as 6% to 8% during the first few years of the annuity's life.

Investors can purchase annuities through insurance companies or through licensed agents. These may include mutual fund companies, banks, insurers, and other parties. Each insurance company and agent is licensed by a particular state. State insurance commissions monitor insurance companies to ensure they have reserve funds, called State Legal Reserve Pools, in place to protect investors before granting an insurance company a license. If an insurance company goes out of business, other insurance companies licensed in state must assume bankrupt insurers' obligations and liabilities. This protection protects fixed-rate annuity holders only, with some protection afforded to variable annuity owners. For most people, it's best to buy an annuity through a large, well-established company. These large companies usually offer the best rates as well.

The Securities and Exchange Commission (SEC), a U.S. governmental body regulates variable annuities. The SEC also oversees stock market, mutual fund, hedge fund, and public company activities. Fixed annuities are not treated as securities and are not regulated by the SEC. Equity-index annuities combine features of traditional insurance products (guaranteed minimum return) and traditional securities (return linked to equity markets). Depending on the mix of features, an equity-indexed annuity may or may not be treated as a security. The typical equity-indexed annuity is not registered with the SEC.

Visit http://www.annuity.com or http://www.insure.com. Talk to a tax professional and be sure to fully understand an annuity's annual fees and expenses before investing.

For more information on individual annuities, visit Vanguard, Fidelity, or T. Rowe Price. These mutual fund companies also sell annuities and generally have better annuity products than the annuities offered by insurance companies.

The Securities and Exchange Commission provides an excellent overview of variable annuities: http://www.sec.gov/investor/pubs/varannty.htm