What is an Annuity Contract?
An annuity is an insurance contract. An annuity may have two different phases – accumulation or payout (also referred to as annuitization). When an annuity is in an “accumulation” phase, it is referred to as deferred. When an annuity is in its payout phase, or annuitization phase, it may pay the contract holder an income stream. The income stream may be for life, a certain period of time (usually years or months), or a combination of both. An annuity that is in a “payout” phase is used by annuitants to provide for a steady flow of income. These are most commonly used in retirement to help replace ones working wages.
When the question of what is an annuity crops up, it is important to address it first through an explanation of what is involved when a person purchases an annuity. A person can purchase an annuity with a series of payments or with a lump sum of money to an insurance company. That insurance company issues a contract between the company and the owner of the annuity. The terms of the contract are clearly laid out so the purchaser has an understanding of what they can expect from the annuity.
Also, when answering the question of what is an Annuity, it is important to understand that there are different kinds of annuities. In general, there are four kinds of annuities: immediate, fixed, variable and indexed. The investor should consider the following factors before choosing the right kind of annuity for him: the years before he stops working, and the amount of money he will receive from other sources. He should consider as well his other assets and savings.
An immediate annuity is one in which a person pays a lump sum of money to an insurance company in exchange for a series of payments. Depending upon the terms of the contract, those payments may be made for a specified time frame, the purchaser’s lifetime, or a combination of both.
A deferred fixed annuity is a guaranteed kind of annuity. A fixed annuity will pay a specified interest rate to the purchaser. This interest rate may be guaranteed for a certain period of time – sometimes one year, and sometimes upwards of 10 years.
In a variable annuity, the investor can choose how he invests his money. Generally speaking, an insurance company will provide a number of mutual funds, known as sub-accounts, in which an investor can invest. He can choose to invest in conservative or aggressive mutual funds. The funds in this type of annuity may grow faster than other types of annuities if the stock market is favorable. However, the investor should understand that the amount he invests could be diminished if the underlying values of the mutual funds go down. Thus, investors should calculate the risks well.
Indexed annuities are somewhat of a hybrid between a fixed annuity and a variable annuity. They have characteristics of both. For one, they usually have a principal guarantee like a fixed annuity. However, they are usually linked to one of the stock market indexes. They may go up in value when the stock market index goes up, thus increasing the value of the annuity. However, in general, they do not usually go down in value if the stock market index goes down. What is the tradeoff? If you purchase an indexed annuity, you must understand that you will not receive all of the upside of stock market gains. You will usually only receive a percentage of the upside in exchange for removing the downside risk of the market.
Annuities are best suited for long term investors. Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax. Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time. Any guarantees on principal invested are based upon the claims paying ability of the underlying insurance company.