Annuity Basics

What is an Annuity?

For those gearing up for retirement, there seem to be countless terms and strategies to know, not the least of which is an annuity. The term annuity is used interchangeably with income, investment vehicle, and retirement account, which makes fully comprehending the definition of an annuity confusing at best. If you’ve heard the term annuity and need some clarification, you’re in the right place.

Defining an Annuity

In the simplest terms, an annuity is a guarantee of income paid to an individual for either a certain period or over the course of one’s lifetime, no matter how short or long that life is. Annuities are, in essence, insurance contracts where the issuing company offers some degree of guarantee on an income stream paid now or in the future. The amount of guaranteed income is based on the amount of money used to fund an annuity contract along with the claims-paying ability of the insurance company issuing the annuity.

One example of an annuity is a traditional pension, where an employee, employer, or combination of the two contributes money to an account over time. Once an eligible employee reaches retirement age, the funds contributed for his or her benefit are guaranteed to be paid out on a systematic basis (i.e., monthly or annually). This is an annuity at work. No matter how long the retiree lives, the pension amount, plus any cost-of-living adjustments if included, are paid as promised.

Because of the guaranteed income aspect, an annuity can be a beneficial tool for retirement. An annuity protects the recipient from outliving their funds, and in some cases, provides continued income to a surviving spouse or beneficiary. Even though this concept seems simple, the terms used to describe annuities and the various categories of annuities can complicate things.

Understanding the components of an annuity along with different flavors of annuities makes it easier to make an informed decision as to whether an annuity is an appropriate choice as part of your unique retirement picture.

Basic Annuity Terms

Below are a handful of basic terms associated with nearly all annuities, meant to provide a deeper understanding of how annuities work.

  • Annuitant: the individual who receives annuity payments and often, the owner of the annuity contract
  • Annuitization: the process of converting a deferred annuity to an income annuity that generates a guaranteed income stream
  • Accumulation phase: the period of time a deferred annuity is invested or earning interest before annuitization takes place
  • Beneficiary: the individual or trust who receives payments after the original annuitant passes away
  • Cash surrender value: the dollar amount or percentage that can be withdrawn from an annuity contract after any fees or penalties are assessed
  • Exclusion ratio: the formula that determines how much of an annuity payment is taxable and how much is tax-free as a return of principal
  • Free-look period: a set number of days within which an annuity contract owner may void the purchase of an annuity
  • Living benefits: various annuity options that may protect against investment risk by way of certain guarantees
  • Mortality and expense risk charge (M&E): the fee assessed in certain annuity contracts for insurance guarantees
  • Payout phase: the period of annuitization when income is paid out
  • Premium: the amount of money paid into an annuity contract
  • Section 1035 Exchange: the term describing a tax-free exchange of an insurance policy or a current annuity for a new annuity contract
  • Surrender charge: the cost of ending an annuity contract before the stated surrender period ends (typically five to seven years)

Types of Annuities

Annuities are available in different types, with most falling under two broad categories: immediate (or income) and deferred. An immediate or income annuity offers a guaranteed income payment to the annuitant for life or a set number of years immediately. With most insurance companies, immediately means within 30 days of establishing and funding a new contract. Income annuities are fixed, and so there is no risk of market fluctuation. However, when you purchase an income annuity, there is generally no provision that you can get your premium back from the insurance company as a single lump sum.

Deferred annuities, on the other hand, guarantee income upon annuitization in the future, typically at least one year after the initial premium payment is made. Within deferred annuities, you have the option to invest in a fixed account that pays a set interest rate, an indexed account that is linked to a market index like the S&P 500, or sub-accounts that resemble mutual funds or exchange-traded funds. Deferred annuities do allow for a withdrawal after purchase, but there may be surrender charges associated with a partial or full withdrawal.

Overall, an annuity can be thought of as a guaranteed income stream either now or in the future. Don’t let the various terms associated with or types of annuities get in the way of your understanding of what they can provide as part of a holistic retirement plan.