Understanding Annuities

An annuity is a contract in which you agree to pay a life insurance company a certain amount of money, either in a lump sum or through a series of payments. In return, the insurer provides you with an income stream beginning either immediately or at a future date. Your income payments may last for a specified time period, or an indefinite period, such as your lifetime or your spouse's lifetime if he or she outlives you.

Immediate versus deferred annuities

With an immediate annuity, you buy the annuity contract with a lump sum payment and begin receiving income right away. For example, you might pay $1 million for an immediate annuity that pays you $5,000 per month for the rest of your life. With a deferred annuity, you contribute your money over a period of time and begin receiving the income at a later date, usually upon retirement.

Fixed versus variable annuities

In a fixed annuity, the insurer guarantees a minimum rate of return on your investment while the account is growing. You then receive a fixed dollar amount - usually as a monthly stipend - during the payout period.

In a variable annuity, your premiums are invested in financial securities, such as stocks or mutual funds. Your rate of return and eventual income from the annuity depend on the performance of your investments.

An equity-indexed annuity combines features of fixed and variable annuities. The rate of return is tied to an equity index, such as the S&P 500. Generally, a portion of your purchase payments is allocated to a fixed account which provides a guaranteed minimum rate of return.

Advantages and disadvantages

The main advantage of annuities is that they can be structured to provide a steady income stream that cannot be outlived. The tax benefit of annuities is generally overstated. Taxes on your earnings are deferred while the account is growing, but the tax treatment is less favorable during the payout period when earnings are taxed as ordinary income. Most annuities lock up your capital providing you with little control over your assets and no access to them without paying exorbitant surrender charges and tax penalties. Finally, the insurance company typically confiscates the remaining assets upon your death. Some annuities offer a death benefit, but this adds yet another charge to the bewildering array of fees and expenses associated with most annuities.

On balance, we take a dim view of annuities. The insurance industry's success in selling them has been referred to as "a testament to the power of marketing over common sense." However, the promise of a lifetime income is alluring to many retirees. In a future newsletter, we will delve a little deeper into annuities and their potential role in your portfolio.

October 2005

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