Sitting somewhere at the intersection between insurance and investments, annuities are confusing and often misunderstood. Some say they’re expensive and not worth the money. To others, they’re the perfect solution to nearly every financial problem. The truth is they’re complicated. Properly understood and used appropriately, annuities solve a financial problem that has no other solution. Along the way, annuities have their own set of costs, issues, and concerns that you must be aware of and should carefully consider.

An annuity is an insurance contract that provides a guaranteed life income that is predictable, secure, and which you (or perhaps you and your spouse) cannot outlive. This guaranteed life income can begin immediately or can be deferred. A deferred annuity can be purchased with a lump sum or through periodic payments and can grow in various investment options. Because retirement income security is an important social goal, the tax code has granted annuities unique tax benefits. At death, the annuity balance avoids probate and passes immediately to the beneficiary. A surviving spouse also has the option of continuing the annuity. Annuities are sold only by insurance companies and their appropriately licensed agents.

Are there other uses for the word "annuity?"

Technically, an annuity is a series of periodic payments, either for a number of years or for life. The person receiving these payments is the annuitant. The payor is the party paying them. An insurance company doesn’t need to be involved. For example, if someone is hurt due to someone else’s negligence, the responsible party may have to pay the injured person’s medical expenses for the rest of their life. This series of payments is an annuity.

The word annuity has a particular meaning in advanced Estate Planning. These are complex concepts that don’t apply to most people’s finances but might help place the term annuity in its proper context.

For any number of reasons, an individual might want to transfer all or some of his assets to another person. He might choose to do this through a trust. A trust is a legal entity that allows the assets in the trust to be managed by a trustee for the benefit of a beneficiary. Or, in this context, two beneficiaries.

Let’s imagine you want your children to receive an asset when you die. In the meantime, you want the income from that asset for yourself and your spouse. You also know that if you leave the asset to your children in your will, it will have to go through probate, a messy, public, and expensive process.

Instead, you could transfer the asset to a particular kind of trust. This trust would pay you (and your spouse) an income from the asset and then would transfer it to your children at your death. Known as a Grantor Retained Annuity Trust, or GRAT, you would be the grantor, the lead beneficiary, and the annuitant. Your children would be the remainder beneficiaries.

If you named a charity instead of your children to receive the asset at your death, the trust would be known as a Charitable Remainder Annuity Trust or CRAT. As in a GRAT, you would be the grantor, the lead beneficiary, and the annuitant, but the charity would be the remainder beneficiary. One of the advantages of a CRAT is that you, the Grantor, could take the Charitable Tax Deduction now, during your lifetime, when it might be more valuable.

Part of the confusion surrounding annuities is the multiple meanings of the word. In this article and elsewhere on this site, we will be using the word annuity to refer to the insurance policy.

What are the different types of annuities?

Another source of confusion is the many dimensions along which annuities are categorized. What is a Deferred, Flexible-Premium, Variable Annuity, and how is it different from an Immediate, Guaranteed, Joint and Survivor Annuity?

Let’s try and sort this out.

All annuities must provide for a guaranteed life income for the annuitant. One of the ways annuities can be categorized is when that income begins.

An Immediate Annuity is one where the income starts immediately, typically within thirty days. But, the income can start anytime in the future. For example, someone in their forties might like the idea of an income they can’t outlive, but they don’t want it to start until they retire. They would purchase a Deferred Annuity. When the income begins is one of the ways to categorize annuities.

How you pay for your annuity is another. If you invest a lump sum into an annuity contract, you’ve purchased a Single Premium Annuity. Immediate Annuities are always Single Premiums. You can also acquire your annuity with a series of payments. These are called Flexible Premium Annuities. While often set up with regular, periodic payments, such as $500 a month, annuities cannot require such payments (except in rare circumstances.) You will not be penalized if you skip a payment or if you stop making them altogether.

Do you have an annuity in your retirement plan or IRA? If so, you have a Qualified Annuity. Otherwise, it’s known as a Non-qualified Annuity. Using tax-deferred retirement plan assets to purchase a tax-deferred annuity is considered controversial as the tax benefits of an annuity don’t apply since the retirement plan has its own, similar set of tax benefits. Still, using retirement assets to fund a guaranteed income in retirement makes sense, and the use of annuities in retirement plans and IRAs is common.

Finally, how are your annuity premiums invested? There are three broad categories.

What is a Fixed Annuity?

Fixed Annuities are annuities that earn regular interest payments each year at a rate that is declared each contract anniversary. Every fixed annuity has a minimum guaranteed rate, below which the declared rate cannot fall. Typically, this is higher than a Bank Savings Account. As with every annuity, the interest is tax-deferred.

Multi-year Guaranteed Annuities or MYGAs are a type of Fixed Annuity. MYGAs can be thought of as CDs from an insurance company. However, MYGA rates are typically higher than the rates for CDs with similar terms. As of this writing, in April of 2021, a three-year CD is paying less than 1%, while several highly rated insurance companies are paying over 2% on three-year MYGAs.

Just like CDs, MYGAs are subject to penalties for premature withdrawals, although those penalties tend to be higher in annuities. Again, like CDs, you’re free to renew, transfer or withdraw your balance at the end of the term. Like all annuities, and unlike CDs, MYGA interest is tax-deferred. You can also withdraw your interest each year. However, if you withdraw your interest, it will be taxable income and, if you’re under age 59 ½ may be subject to a tax penalty.

MYGAs have become very popular in recent years, with billions of dollars invested, as interest rates have remained low.

What is a Variable Annuity?

A Variable Annuity is an annuity that is invested in a portfolio of mutual funds. Like with mutual funds and other investment vehicles, the balance in a Variable Annuity account will vary, up and down with the markets. Variable Annuities typically have higher expenses that than equivalent mutual funds and these expenses can be a substantial drain on your returns over time. However, the growth in Variable Annuities,  like all annuities, is tax deferred. Variable Annuities also have optional benefits that can enhance the income death and the death benefit.

What is an Equity Index Annuity?

An Equity Index Annuity is similar to a Fixed Annuity and has a guarantee of principal and interest. Typically they also have a minimum declared rate of interest. Unique to this type of annuity is the way interest is credited. Interest is based upon the performance of an index, often the S+P 500. If the index has a positive return during the year the annuity, the annuity will have a positive return for that year. However, if the index has a negative year, the annuity will return zero. As with any fixed annuity returns can never be negative.

Conclusion

Annuities can be Immediate or Deferred, Single Premium or Flexible-Premium, Qualified or Non-Qualified, and they can be Fixed, Variable and Equity Indexed.