Annuities are one of the most confounding and controversial products in the “investments” world. I put investments in quotation marks, since annuities are actually life insurance products, and not strictly investments. You may find these definitions helpful.
Annuity contracts
are typically purchased for retirement funding, and by definition offer an income for life feature. When annuitized, annuity contracts can offer monthly income, with the payment generally a function of age, interest rates, accumulation value, and life expectancy.
Accumulation value
is another word for the account or cash value, and grows based on interest rates in a fixed annuity, and based on mutual fund-like investments in variable annuities. The death benefit – available in most deferred annuities before they are converted to lifetime income by annuitization – is often the same as the accumulation value, or the total invested, whichever is greater. Often you are guaranteed to get no less than you invested if you die.
Surrender charges
are usually imposed in the early years of an annuity contract’s life as a way to reimburse insurance companies for commission costs. Many annuities are distributed by financial advisors paid on a commission basis. Consumers should carefully consider an annuity offered to determine costs and benefits before deciding to buy an annuity.
Type of annuity: immediate or deferred.
There are two basic distinctions when looking at annuities. The first is between deferred and immediate annuities. With immediate annuities, the monthly payments begin immediately, and often all access to principal is forever lost.
One basically trades their money for a lifetime stream of payments like a pension. Deferred annuities are basically accumulation vehicles, and intended to grow as retirement accounts to be converted to lifetime income at some point in the future.
Type of annuity: fixed or variable.
The other distinction is in how the accumulation value is invested. Fixed annuities pay interest at a fixed rate, and variable annuities offer mutual-fund-like investments with the possibility of higher returns, but also higher risk.
Type of annuity: equity index.
Another sort is the so-called “equity index annuity.” These are really fixed annuities whose interest rate is a function of some risk-based index, like the S&P 500.
Because they are fixed, equity index products are not overseen by securities regulators, which some critics have suggested reduces consumer disclosure and may promote misleading and abusive sales practices.
Also because they are fixed (see What are the types of fees associated with annuities? below) it is difficult to find the true costs in these products.
These often include high – sometimes very high – surrender charges, limitations on what you can make due to participation rates and index caps, as well as other costs such as market value adjustments (MVAs), and guarantees which are for less than what you might invest.
Tax treatment
For annuities that are not in IRAs or other types of retirement plans, any growth occurs tax deferred. Ultimately the tax must be paid, however, and tax rate and method can often be much more expensive compared to other types of investments, since ordinary income rates (your highest bracket) instead of capital gains rates apply. There is also a pre 59 ½ 10% excise tax, and capital gains taxes are not waived at death as is the case for most other investments.
Longevity Annuities
are special products designed to insure against the risk of running out of money if you live longer than expected, and into advanced old age. With these, you pay a premium to an insurance company, in return for lifetime payments that start later in life, sometimes as late as 85.
Many have tax advantages related to avoiding normal required minimum distribution rules. The basic tradeoff is if you die younger, you lose the benefit of the capital tied up in premium, but if you live long and exhaust your other assets, the longevity annuity payments keep your lifestyle going.