What Are Annuities?

Annuities are contracts between a life insurance company and a buyer. These contracts allow the buyer to make a single investment, or a series of investments, throughout the "accumulation period" during which money grows, tax deferred. 

At the end of the accumulation period, the contract provides a lump-sum payment or a series of payments which may include some of the following variations:

Income for life with:
  • nothing remaining upon death
  • 10-20 years of guaranteed payments to a beneficiary
  • a lump-sum payment at death equal to the difference between the fund balance and payments received
  • payments continued at some level for the life of a survivor
  • a specified period or amount
Annuities are most often used as a long-term investment for retirement. There are three types of deferred annuities: fixed, variable, and market-value-adjusted (hybrid). The fixed and variable deferred annuities are further classified as single premium deferred (SPD) and flexible premium deferred (FPD) depending on the number of deposits allowed. In addition to deferred annuities, there are immediate annuities.

Deferred Annuities: 
A fixed annuity credits interest based on the earnings of the company's general account. Both investment and mortality risks are borne by the company. Contract rates of return have a guaranteed minimum rate which is reset periodically. The guarantee periods vary and may range from one to 10 years.

In contrast to fixed annuities, variable annuities offer greater investor flexibility in that they allow the annuitant to select from several investment options and their corresponding returns are credited to the annuitant. The variable annuity is best explained as a mutual fund family within an insurance contract. 

The insurance company offers a mix of stock, bond, and money market funds and places allocation and selection responsibility directly on the policyholder. Therefore, investment risk is borne by the purchaser. The value of the account fluctuates with the changing market values of the underlying securities held. The variable annuity, however, differs from the mutual fund investment in one way—taxation.
If a taxable mutual fund is owned, all earnings would be taxable in the year paid. This includes realized capital gains. This is not the case with a variable annuity.

During the accumulation period, the investor incurs no income tax liability for reinvested dividends, interest, or realized capital gains. The insurance company pays a corporate capital gains tax on realized capital gains; a proportionate amount of that tax may be deducted from the benefits credited to the annuitant's account.

Market-value-adjusted deferred annuities are a hybrid of fixed and variable annuities. They provide a guaranteed interest rate for a specific period of time—usually 10 years. If, however, the contract is surrendered before the end of the guarantee period, adjustments are made to the cash value of the contract. Hybrids were developed to connect the temporary cash values to changes in the market value of the underlying investments caused by fluctuating interest rates.
Immediate Annuities: Immediate annuities provide a series of payments as soon as the premium is paid to the company. With fixed immediate annuities, payments are fixed at issue. With variable immediate annuities, payments vary based on the performance of the funds selected.