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Annuity

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An annuity is a contract between an insurance company and a person that provides for periodic payments to the individual or designated beneficiary in return for an investment.

1 Expanded Definition
2 Fixed Annuity
3 Variable Annuity
4 Related Fool Articles
5 Related Terms
6 Recent Mentions on Fool.com

Expanded Definition

Typically, an annuity agrees to provide payments to the purchaser of the contract (annuitant) beginning at some point in the future. Two kinds of annuities are most common: variable annuities and fixed annuities.

Fixed Annuity

A fixed annuity is a contract to pay a specific payee a specified amount for a specified period. The contract is similar to a company pension plan. The basic product usually will pay a specified amount per month to the retiree for life. However, numerous modifications are offered. The payments may be made to the individual or to his spouse, or may pay a reduced amount to the spouse. The payments may be for a specified period, or for a specified minimum period.

The amount paid for a fixed annuity is determined by the life expectancy of the individual insured. The same actuarial tables used for life insurance determine the cost of your contract. Hence, your age and sex affect the cost. Interest rates when the policy is sold are also a factor. High interest rates give lower prices or higher payouts.

The insurance company assumes the risk that you will live far longer than the actuarial tables indicate. In the case of a life payment plan, they will pay for life. But similarly if you die before the calculated time, the insurance company keeps the rest of your money. A minimum payment period can be used to guarantee at least a minimum number of payments. Then the payments are made to your designated beneficiary.

Most annuities pay a fixed payment for life. Hence, they offer no protection from inflation. However, contracts are available that will ramp up payments at a specified rate say 3% per year. This feature too increases the cost of the contract.

Variable Annuity

A variable annuity has an accumulation period. The funds you contribute are invested in a specified portfolio and allowed to grow tax free. On a specified date, usually after age 59-1/2 you can annuitize the contract and begin taking distributions. That means the cash value of your investment account is converted to a fixed annuity as described above.

Variable annuities are heavily promoted by insurance agents. They pay high commissions. The fees charged to manage the funds can be quite high, and surrender charges can be payable for as long as seven years if you remove your money prior to a specified date.

These days index annuities are popular. They usually are claimed to allow your funds to grow with the stock market while protecting you from losses. The protection takes the form of a guarantee that your account balance will be annuitized at no less than the amount you contributed, sometimes with some percentage escalator. The deficiency reported by many is that the gains are capped at a specific amount per year or quarter. Hence, in a good year, you often max out your gain while the market continues higher. Then in a bad year, you may not gain much. Meanwhile the guaranteed floor does not come into play until you have lost nearly all your gains.

Annuities can be appropriate for some. Your funds are professionally managed, and you have no concerns that you will outlive your funds or your investments will fail to provide for your needs. But most individuals would be better off to invest in good quality mutual funds where fees are lower and you can more easily move your funds if performance does not live up to promises.