Introduction to Annuities
Mutual funds, bank certificates of deposit, 401(k) accounts, individual retirement accounts — we hear about these investment and retirement savings vehicles nearly every day. We’re inundated with advertisements for financial products, yet we don’t see television ads for annuities; we don’t often hear about them on the radio, or see their ads in newspapers. Why, when banks and brokerage firms are constantly vying for our retirement dollar, don’t we hear more about annuities?

The reason is simple: annuity products are extremely complicated, and their terms and rates fluctuate constantly. You might protest that the stock market is complicated, but day-traders have been making and losing money for years. That’s certainly true, but the operative word in that sentence is “losing”, not “making”. As the number of retired persons in America grows, the importance of good retirement and estate planning increases as well. As we take a short look at the history of annuities, you’ll see how annuities have changed to adapt to such shifts in focus, becoming uniquely suited to the kinds of steady growth desired by today’s retirees.


History
To understand annuities and the way they work, it’s a good idea to look at their origins. Annuities were created to liquidate capital and provide an income of sorts during retirement. As such, annuities in the beginning were much more concerned with the dispensation of money than they were with its accumulation.

Every annuity contract can be “annuitized”, that is, converted to a series of payments. These payments can be paid out over a sum of years according to the contract, or they can be paid out for a “lifetime” (estimated actuarially).

Eventually, annuity holders became just as interested in accumulating money for retirement as they were in how it was disbursed. This lead to improved options for interest rates, a focus on the earning power of tax deferral, and to the development of a great many different annuity products.

That’s the reason we at AnnuiWeb like to suggest that everyone speak with an agent in their area — annuities are complicated contracts, and the more you know about what you’re signing, the better for all involved.


Why Insurance Companies?
Well, first of all, you can purchase annuity contracts from other sources besides insurance companies, like independent financial planners and some banks, but the bulk of all annuity products are offered by insurance companies. Having looked at a little of the history of annuities and their development, we can see why life insurance companies are uniquely suited to the annuity business.

In essence, both life insurance and annuities deal with mortality estimation. For life insurance, a mortality-based product, the insurance company sells policies at costs based on scientifically derived estimates of the contract holder’s longevity, taking the risk that the contract holder might die before enough premium has been paid to cover the cost of disbursements.

With annuities, which are asset management products, the insurance company assumes the risk that a contract holder who has annuitized their annuity into a lifetime payment might live well beyond the actuarial estimate. Both life insurance and annuities rely on these mortality estimates, albeit in different ways, and life insurance companies had already been in the business of estimating mortality for years.


Types of Annuities
You can think of the types of annuities like a branching tree; the further down the branch you go, the more branches there become. Let’s start from the top.

Fixed vs. Variable
Essentially, all annuities are either fixed or variable. A fixed annuity minimizes your risk in every way possible by providing a guaranteed return. You as the contract holder know what you will earn each year and for how many years right from the outset. Fixed annuities are extremely conservative; because the risk burden is assumed by the insurance company (if they don’t make as much money from their investments as they’re contractually obligated to pay out to contract holders, they don’t make a profit on that contract), fixed annuities typically have lower rates of return than other annuities.

Variable annuities, on the other hand, shift more of the risk to you as contract holder, but provide a greater opportunity for earnings, and a great deal of flexibility in terms of premium management. Typically, a variable annuity has both a general account which earns a guaranteed return, and a separate or sub-account which has greater earnings potential but no guarantee. You as the contract holder can determine what percentages of your premium occupy each account, based largely on your investment goals. Because variable annuities inherently carry risk, they are considered “securities” and regulated by the Securities and Exchange Commission (SEC). Any annuity agent must be licensed in the state in which they operate, and most carry multiple licenses, as well as licenses with Federal regulatory groups.

Really the differences between fixed and variable annuities boil down to how much risk you’d like to assume. Greater risk can equal greater reward, but security can be a nice benefit, too. Once you decide how much risk is to your liking, there are other choices to make.

Immediate vs. Deferred Annuities
Basically, when do you want your money back? As the name would imply, an immediate annuity starts paying you back right away (usually between one and thirteen months from the contract’s origination date). Immediate annuities can vary greatly in type and design, but they can only be purchased with a single, lump-sum premium.

So once your immediate annuity begins paying you, how long do these payments last? This depends partly on the premium invested, also on the distribution option (monthly, semi-annually, annually, etc.) you select. Payments can last for a scheduled amount of time, like 10 or 20 years (term certain); for the duration of the annuitant’s life (life-income); or for the duration of two persons’ lives (joint and survivor). Sometimes these options are combined. No matter which option you choose, however, the longer the distribution period, the smaller each individual payment will be.

As the baby boomers retire, there is a great deal of innovation on the immediate annuity front to make the products more attractive. Expanded options for liquidity and flexibility remove some of the “inflexible” stigma from annuities, and make them more and more competitive.

Deferred annuities are also riding the crest of a wave of innovation which has lead most notably to the creation of the equity-indexed annuity (more about that later). All deferred annuities have things in common, however: their tax-advantaged status and their flexibility.

Think of deferred annuities as a contract with two phases: an accumulation phase, and a distribution phase. During the accumulation phase, your fund earns interest in three ways: interest on your initial premium, interest on the interest you’ve earned, and interest on the money you would have paid in taxes. This deferred “triple-threat” enables tax-advantaged investments to increase at a much faster rate than comparable taxed plans.

During the distribution phase, each contract can have many different options for getting your money to you. Often, you can take a lump-sum distribution of the entire cash value, or annuitize to take advantage of systematic disbursements geared toward your lifetime.

Qualified vs. Non-Qualified (Annuities & IRAs)
Did you know that you can use annuities to fund individual retirement accounts (IRAs)? Given their highly competitive rates of return, annuities make great vehicles for funding an IRA or similar retirement plan. To understand how this works, we’ll first need to define qualified and non-qualified.

Put simply, a non-qualified annuity can be purchased by anyone at any time. Most flexible premium annuities fall into this category — flexible premium annuities are those where periodic payments can be made to increase the annuity principal (as opposed to single-premium annuities which are purchased with a single lump sum). Non-qualified annuities are funded through taxed income, whereas qualified annuities can be funded with pre-tax dollars.