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Investment Products

Annuities

Investing

ESSENTIALS

  • Annuities, which are contracts with insurance companies, are products that investors might consider when planning for retirement or seeking to turn assets into a stream of income.
  • Money invested in annuities grows on a tax-deferred basis.
  • While all annuities are regulated by state insurance commissioners, variable annuities are also regulated at the federal level by the U.S. Securities and Exchange Commission (SEC) and FINRA.
  • Annuities may be either immediate or deferred, depending on when you start receiving payments.
  • The different types of annuities—fixed, variable and indexed—come with different risks and potential rewards. Take time to learn the differences and compare annuities to other retirement savings vehicles to determine what will best meet your needs.
  • Annuities are complex and can be costly. Make sure you understand all the fees, expenses, charges, and any features or added benefits (often sold as “riders” at an additional cost) before making a purchase.
  • Variable annuities can feature surrender periods of eight years or more. During this time, you can be assessed penalties if you liquidate your annuity. Therefore, you should give careful consideration to how much of your funds are concentrated in the investment and your need for liquidity during the surrender period.

An annuity is a contract between you and an insurance company in which the company promises to make periodic payments to you, starting immediately or at some future time. You buy an annuity either with a single payment or a series of payments called premiums.

Some annuity contracts provide a way to save for retirement. Others can turn your existing savings into a stream of retirement income. Still others do both. If you use an annuity as a savings vehicle and the insurance company delays your payout for the future, you have a deferred annuity. If you use the annuity to create a source of retirement income and your payments start right away, you have an immediate annuity.

Both immediate and deferred annuities can be either fixed or variable, which changes the risk profile of your investment. Indexed annuities, also called equity-indexed or fixed-index annuities, are a hybrid. While all annuities are regulated by state insurance commissioners, variable annuities are securities and therefore are also regulated by the SEC and FINRA. Certain forms of these annuities are also sometimes referred to as “buffer annuities.” Buffer annuities can feature both upside limits and downside protection and can have complex structures with similarities to options contracts.

Annuities are often products investors consider when they plan for retirement. They are often marketed as tax-deferred savings products. However, they come with a variety of fees and expenses—such as surrender charges, mortality and expense risk charges and administrative fees—and can have high commissions. You may also incur charges for special features and riders, such as stepped-up death benefits, guaranteed minimum income benefits, long-term health insurance or principal protection.

In addition, there may be state guarantees in the event of an insurance company's failure, but annuities are not guaranteed by the FDIC, SIPC or any other federal agency.

Annuities are a popular choice for those seeking certainty and predictable income streams in retirement; however, they can also be complex and confusing. Be sure to understand the contract features and riders, costs, and restrictions involved before making an annuities purchase.

There are three types of annuities: fixed, variable or indexed.

Fixed Annuities

With a fixed annuity, the insurance company guarantees both the rate of return (the interest rate) and the payout to the investor. The interest rate on a fixed annuity can change over time. Often the interest rate is fixed for a number of years and then changes periodically based on current rates. Payouts can be for an entire lifetime, or you can choose another time period.

With a deferred fixed annuity, the insurance company agrees to pay you no less than a specified rate of interest during the time that your account is growing. With an immediate fixed annuity—or when you "annuitize" your deferred annuity—you receive a predetermined fixed amount of money, usually on a monthly basis (similar to a pension). These payments may last for a specified period, such as 25 years, or an unspecified period such as your lifetime or the lifetime of you and your spouse.

The predictability of a fixed annuity makes it a popular option for investors who want a guaranteed income stream to supplement their other investment and retirement income. Fixed annuity payouts are not affected by fluctuations in the market, so they can provide peace of mind for investors who want to ensure that they will have a predetermined amount of money to carry them through retirement and cover identified future expenses.

Variable Annuities

Variable annuities offer investors choices among a number of complex contract features and options. With variable annuities, the rate of return—and therefore the value of your investment—might go up or down depending on the performance of the stock, bond and money market funds that you choose as investment options.

Variable annuities are sometimes compared to mutual funds because they offer similar investment features, including investment choices—called "separate accounts"—that resemble mutual funds. However, a typical variable annuity offers three basic features not commonly found in mutual funds:

  • tax-deferred treatment of earnings;
  • a death benefit; and
  • annuity payout options that can provide guaranteed income for life.

While a variable annuity has the benefit of tax-deferred growth, its annual expenses are likely to be much higher than the expenses of a typical mutual fund. And, unlike a fixed annuity, variable annuities do not provide any guarantee that you will earn a return on your investment. Instead, there is a risk that you could actually lose money.

Variable annuities generally offer death benefits, meaning that if you die before the insurance company has started making payments, a designated beneficiary will receive a specified amount. However, unlike a term life policy, where the beneficiaries in most instances receive more than the premiums made, beneficiaries of variable annuities generally receive the premium, net of any withdrawals, and nothing more.

In general, variable annuities have two phases: 1) the "accumulation" phase, when the premiums you pay are allocated among investment portfolios, or subaccounts, and your earnings on these investments accumulate; and 2) the "distribution" phase, when the insurance company guarantees a minimum payment to you based on the principle and investment returns (positive or negative).

Due to the complexity of variable annuities, they are a leading source of investor complaints to FINRA. Before buying a variable annuity, carefully read the annuity’s prospectus, and ask the person selling the annuity to explain all of the product’s features, riders, costs and restrictions. You should also know how your broker is being compensated, including whether they are receiving a commission and, if so, how much.

You can check whether your broker is licensed or has a history of complaints by going to FINRA's BrokerCheck.

Indexed Annuities

Indexed annuities are complex financial instruments that have characteristics of both fixed and variable annuities. Indexed annuities offer a minimum guaranteed interest rate combined with an interest rate linked to a market index.

Many indexed annuities are based on broad, well-known indexes like the S&P 500 Index. But some use other indexes, including those that represent other segments of the market. Some indexed annuities allow investors to select one or more indexes. Indexed annuities expose you to more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity.

Understanding the features of an indexed annuity can be confusing. There are several indexing methods firms use to calculate gains and, because of the variety and complexity of the methods used to credit interest, it is difficult to compare one indexed annuity to another.

Indexed annuities offer protection on downside risk with a guaranteed minimum return, typically at least 87.5 percent of the premium paid at 1 to 3 percent interest. With these products, sometimes referred to as “buffer annuities,” you are protected up to a set percentage of loss; if the index linked to your annuity declines beyond that “buffer,” you can lose money on your investment. Equity-indexed, or fixed-indexed, annuities guarantee that you will not lose your principal investment; however, fees and expenses may exceed the minimum returns and could still result in a loss. And, as with other annuities, significant charges and penalties may apply if you surrender your annuity early.

Before purchasing an indexed annuity, make sure you not only understand each feature, but also how the features work together. This combination can have a significant impact on your return. You can also use BrokerCheck to find out whether the person selling an indexed annuity is registered with FINRA.

When buying an immediate annuity, you pay a lump sum premium to an insurance company in exchange for an income stream that comes immediately or soon after. With a deferred annuity, you invest at some earlier date, or over time, and receive payments at a point in the future. The time between when you start paying premiums and when income payments start is known as an accumulation period.

Payout Options

There are various payout options for deferred annuities. You can choose to “annuitize” or convert the investments in a deferred annuity into guaranteed income for a certain period or for the rest of your life. The decision to annuitize is generally irrevocable. You give up all control over your money in exchange for the guarantee of a steady income stream.

Alternatively, you can make systematic withdrawals from your account or get a lump sum payment. You maintain control of your investment, but you forfeit the guarantee from the insurance company that you will not outlive your money.

Exchanging or Replacing Your Current Annuity

If you already have an annuity, you may be presented with an option to exchange or replace it. If you consider exchanging or replacing your annuity, be sure to do a close comparison with your existing annuity, and only make a change when it is better for you, not just better for the person trying to sell you a new product. Remember that exchanging one contract for a new one may involve additional costs and fees and usually means the clock restarts for purposes of early withdrawal penalties.

An investor considering an exchange of a fixed annuity for a variable annuity should be aware that, unlike a fixed annuity, a variable annuity lacks certain guarantees and can be affected by fluctuations in the market. Also, with the addition of benefits (added as riders), certain variable annuities can be more expensive than fixed annuities.

If you do exchange your annuity, there can be benefits to what is called a "1035 exchange," which refers to a provision in the U.S. tax code that permits a direct transfer of funds in a life insurance policy, endowment policy or annuity policy to another policy without tax consequences.

Buyout Offers

If you own a variable annuity, you may receive a buyout offer from the insurance company asking you to increase your contract value in exchange for giving up a benefit or increase your cash surrender value in exchange for surrendering your variable annuity. Accepting a buyout offer may cause you to lose valuable benefits or enhancements to your existing investment that you have been paying for over time. If you consider accepting a buyout with the intention of moving into a new annuity, you should be aware of the financial impact, which could include a new surrender charge period, less favorable benefits, and higher fees and expenses.

Ask questions, and understand the facts surrounding a buyout offer in order to determine whether it is in your best interest to accept.

Annuities and Taxes

You do not have to pay taxes on any growth in an annuity until you start making withdrawals, but investments in annuities are made with after-tax dollars, meaning you cannot deduct contributions to an annuity from your taxable income.

Unlike other retirement accounts that offer tax-deferred growth, like individual retirement accounts (IRAs) and 401(k)s, annuities do not have annual contribution limits; however, if you invest in an annuity through a qualified plan like an IRA, you are subject to the limits of that plan. Also, if you invest in annuities offered within an IRA or a 401(k), you get no additional tax advantages.

When you do take money out of an annuity, gains are taxed at ordinary income rates. And if you withdraw money before you turn 59½, you may face a 10 percent tax penalty.

Most investors should think about annuities only after they have maxed out their before-tax retirement plans and should consult with a tax professional before purchasing or withdrawing any funds from an annuity.

Both immediate and deferred annuities can be either fixed or variable, which changes the risk profile of your investment.

Company or Credit Risk

With all annuities, investors should remember that the annuity is only guaranteed as long as the insurance company issuing it remains in business, so you will want to be sure you are comfortable with the issuer, not just the product itself. Companies such as Standard & Poor’s provide ratings of insurance companies.

Inflation Risk

Payments in a fixed annuity typically do not have cost-of-living adjustments to keep pace with inflation, so the value of the money you receive in your payments may decline over time. Annuities with inflation protection can be purchased, but the cost, in general, is significantly higher.

Interest Rate Risk

Because the interest rate of a fixed annuity may change after an initial fixed period, your returns may end up paying you less over time. Read your contract to understand how and when your interest rate changes might occur. Additionally, whenever you lock in a rate, whether with a fixed deferred annuity or a CD, you face the risk that you will miss out in the event interest rates move up.

Liquidity Risk (or Withdrawal Risk)

Many annuities have set holding periods and surrender charges for those who want to withdraw their cash early. And even if you manage to skip the surrender charge, you still may face a steep tax penalty for certain withdrawals.

Death Risk

Whether an annuity will continue payments to a beneficiary after your death depends upon the type of annuity and its specific provisions. Even if you only receive a few payments under an annuity contract, the insurance company may not be obligated to continue payments to your spouse or refund your premiums to your estate. Variable annuities typically include a death benefit; however, other types of annuities may not. You may be able to purchase a rider to allow your beneficiaries to receive some money from the annuity.

Accumulation Period
The accumulation period is the time period during which the owner of an annuity makes payments into their annuity and accumulates assets.

Annuitant
The annuitant is the person whose life expectancy determines the payout benefits. The annuitant and the contract owner may be the same person.

Annuitization
Annuitization is the process of converting an annuity investment into a stream of regular payments for as long as the annuitant is living or for a specified number of years.

Beneficiary
The beneficiary is the person designated by the contract owner to receive any benefits due upon the death of the annuitant or contract owner.

Contract Owner
The contract owner is the person, or persons, who pays the premium for the annuity. The owner can make withdrawals and investment decisions, surrender the contract, change the beneficiary and convert a deferred contract to an immediate income stream.

Deferred Annuity
A deferred annuity is an annuity where the contract owner contributes money as a lump sum or with premiums over time and the payout phase is delayed until a future date.

Fixed Annuity
A fixed annuity is an annuity that guarantees both the rate of return and the payout.

Free-Look Period
The free-look period is a set time period within which the purchaser of a new annuity contract can cancel the contract without having to pay surrender charges.

Immediate Annuity
An immediate annuity is an annuity contract, purchased with a lump sum contribution, that pays the owner a guaranteed income starting typically within one month to a year of purchase.

Indexed Annuity
An indexed annuity is an annuity for which the payouts are based on the returns of a stock market index, like the S&P 500, but that typically includes some protection against poor market performance.

Payout Phase
The payout phase is the period during which the money accumulated in an annuity is paid out as income payments.

Premium
In relation to annuities, a premium is the amount paid into the annuity by the contract owner.

Surrender Charge
The surrender charge is the penalty fee owed by a contract owner who sells or withdraws money from the annuity during the surrender period.

Surrender Period
The surrender period is a set period of time after the purchase of an annuity. The surrender period will be detailed in the annuity contract.

Variable Annuity
A variable annuity is an annuity for which the rate of return varies based on the performance of the chosen investment options.

Annuities are complex investment vehicles, and there can be significant differences from one annuity to another.

The following resources provide additional information about annuities, their risks and benefits, and whether this type of investment is the right choice for you.