If you ask an annuity salesman, the answer would be “whatever you want it to do”.  I bring that up because annuities are a very flexible product that can serve a great purpose.  However, sometimes they are oversold and end up being a square peg inserted into a round hole.  Let’s discuss them.

An annuity is technically an insurance contract sold by an insurance company.  The main benefits of an annuity are tax deferral and potential lifetime income.  Yes, there are other things that exist in different types of annuities, but those are the main two things an annuity offers that are hard to find elsewhere.

There are two phases of an annuity.  The first phase is the accumulation phase.  That is when deposits are made to the annuity. Most annuities are simply given 1 deposit in a lump sum.  However, there are annuities that can take in multiple deposits.  The reason that most of them only use 1 deposit is that there are surrender fees that exist in most annuities, and it can get pretty complicated with multiple deposits from both the tax and fee side of things.  It is typically simpler to buy a new annuity if you want to deposit more money.

The second phase of an annuity is the distribution phase.  That is when you take money out of it.  Typically, there are 3 ways to do it.  The first way is through annuitization.  While this isn’t very common anymore, it still does exist.  When you “annuitize” an annuity, the insurance company agrees to pay you an annual payment for the rest of your life in exchange for giving up the lump sum you deposited.  Of course this works great if you live a very long time.  However, if you die soon, the insurance company wins in a major way.  Now there are ways to overcome a near term death by having a “period certain” within the annuitization, but like anything, make sure you have a deep understanding of this before you make any decisions.

The next way to take a distribution from an annuity is more common.  This is through 1 or multiple lump sums.  Let’s say that you have $500,000 as the balance of an annuity.  If you want to take $25,000 per year out of it, you can do that so long as you don’t run out of money.  It would work the same as a brokerage or savings account.  It is very simple.  If you have money, you can take some out.  If not, you can’t.

The third way that a lot of insurance companies are offering is for a lifetime payout rider.  That means that you typically won’t get quite as much income as you would if you annuitized, however if you die sooner, the lump sum you have left will still be there for your beneficiaries.  Payout options like this are becoming more common in the annuity business these days.

Let’s go through the tax deferral aspect of the annuity.  When you put money into an annuity, it can grow tax deferred.  You won’t get taxed on that money until you take it out of your account after age 59½.  The bad news about this is that you will be taxed on the first money you take out of the annuity (assuming it is a gain) and it is taxed at ordinary income instead of long term capital gains (income tax rates are typically higher than capital gains tax rates).  This can be a great feature if you want to defer taxes.  Also, there are no RMD’s if the annuity is outside of an IRA.  So, you will not be obligated to take any money out if you do not want to do so. 

The second reason people buy annuities are the bells and whistles that annuities offer people.    Before we get into them, let’s discuss the 3 basic types of annuities.  They are variable, indexed, and fixed.

A variable annuity is an annuity that can be tied to various mutual funds for better or for worse.  It is very simple.  If the fund sub-accounts you pick within the annuity make money, you make money.  If they lose money, you lose money.  The main benefit for a variable annuity is the tax deferral of non-qualified money.

The second type of an annuity is a fixed annuity.  It will give you a fixed rate of return.  The rate won’t be very exciting as it is usually designed just to beat a CD.  However, if you are looking for tax deferral and want to defer some taxes on the gains, it may be something to consider.

The third type of an annuity is an equity indexed annuity.  It is kind of a mix of a variable annuity and a fixed annuity.  You typically get some type of market correlation with a built-in risk management point.  For example, the annuity may offer you upside on the stock market up to 4% (totally making up that number by the way, so don’t read into it).  Yes, you get that potential upside, but you don’t get anything past 4% (or whatever number the insurance company promises).  The flip side to it is that you are guaranteed to not lose any money.  As the annuity salesmen say, “zero is your hero”.  This can act as an alternative in the safer section of your overall portfolio. 

With any of those three annuity styles, there are certain bells and whistles that insurance companies can offer.  For example, there are some variable annuities that offer a guaranteed lifetime income rider.  That means that even if the market goes down significantly after 10 years, you will still have a lifetime income guarantee.  Other annuities offer stepped up death benefits.  There are a lot of different things that annuities can do.  You just have to see if one would possibly work for you.

While annuities do have some great features, there are some bad parts to them as well.  The main one that most people complain about is the fees.  There are typically a lot of fees in all three types of these annuities.  Yes, you don’t see the fees on fixed and indexed annuities, but they are all baked into the fixed and/or indexed rates.  There is nothing wrong with fees, but make sure you understand what you are being charged before signing on the dotted line.

The other key drawback to an annuity is the surrender fees.  On a lot of annuities, there is a significant fee if you want to close the annuity (in other words get your money back) before the surrender period is over.  A lot of times the “surrender period” can last 7-10 years.  Yes, there are annuities with lesser surrender periods (and some of them have none), but make sure you understand these before you get into one.

In closing, I typically like to use them as a conservative investment alternative within the safer section of a client’s portfolio.  I don’t think that they are a good fit for everyone, but I do see the benefits of the product if it is a good fit for a specific situation.