What is an Annuity?

Annuities have been around in one form or another since the dawn of time. They were used during the Roman Empire as retirement savings plans and have survived in one form or another until today. And they are more relevant and useful than ever, with many retirees depending on the income generated by these vehicles to help pay for their living expenses. 

Modern Annuity Contract

Commercial annuity contracts today are agreements between investors and life insurance companies where the investor pays the insurance company either a lump sum or stream of income for a period of time, then collects the money in the contract as either a lump sum or (more commonly) a stream of income.

Immediate annuities begin paying a stream of income right away, while deferred annuities grow for a period of time before paying anything. Any distribution taken from an annuity before the contract owner reaches age 59 1/2 will be assessed a 10% early withdrawal penalty by the IRS (unless a qualified exception applies). 

Parties to Annuities

The standard annuity contract today binds four parties together. The parties are:

  • The contract owner – the person responsible for paying the premium into the contract.
  • The annuitant – the person whose life expectancy is used to calculate payments. 
  • The beneficiary – the person who will receive the annuity payments from the contract.
  • The Insurer – the life insurance company that issues the contract. 

The owner, annuitant and beneficiary can all be the same person (and usually are). 

Annuity Characteristics

Annuities are fundamentally unique in the investment world in that they are the only vehicle that grows tax-deferred. All other types of investments must be placed inside an IRA or qualified plans in order to do this. There is also no contribution limit for annuities, making them attractive vehicles for wealthy clients.

You can contribute a million dollars into an annuity in one lump sum, and the whole million would grow tax-deferred. Annuities are also unique in that they can pay a stream of income for life, even if the entire contract balance is exhausted.

This was initially the whole reason that people bought annuities, because it provides a form of income protection that cannot be matched with any other type investment. But annuities today are used for many purposes, although their guaranteed payouts are still the primary advantage that they offer. 

Annuity  Payout Options

When the time comes for you to begin drawing income from your annuity, there are several options to choose from. The life payouts require the contract owner to annuitize the contract, which will irrevocably convert the contract to payout mode. 

Systematic withdrawal – this is just a straight dollar payout with no guarantees attached. 

Period certain – again, a straight dollar payout for a set period of time. 

Interest-only – pays out some or all of the interest earned and leaves the principal untouched.

Straight life – payments that are made over the duration of the lives one or two beneficiaries. The insurer will calculate the amount of the payment based on your life expectancy. 

Life with period certain – Guarantees that a minimum number of payments are made if the beneficiary dies early. For example, a 20 year life with period certain would pay 15 years of payments to the contingent beneficiary if the primary beneficiary died after 5 years. 

Joint life – a payout based on the joint life expectancies of a couple.

Joint life with period certain – a combination of joint life with a period certain. 

The more guarantees you have in your payout, the lower your payments will be. Straight life is therefore the cheapest payout and makes the highest payment, because the insurance company will get to keep your contract balance if you die before you’ve received all of your premiums paid back. 

Fixed, Indexed and Variable Annuities

There are three types of deferred annuities: fixed, indexed and variable. Fixed annuities are simply contracts that pay the investor a set rate of interest for a set period of time, such as five years. They may also be paying out a stream of income while they grow. But the principal and interest in fixed annuities are both guaranteed by the insurance carrier.

In fact, all annuity carriers are required to maintain cash reserves that match the amounts of their outstanding contracts on a dollar-for-dollar basis. 

Indexed annuities are a special type of fixed annuities. The interest that you earn from an indexed contract is not guaranteed, but is based on the performance of an underlying financial benchmark, such as the Standard & Poor’s 500 Index.

When the benchmark index rises, you earn interest based on how much it rises. Interest is only credited on the contract anniversary date, which could be a month, a year or every 2 years. Therefore, the contract anniversary date is the only time at which you will be credited for the past crediting period. But once you are credited with the interest earned during your last crediting period, you cannot lose it for any reason.

In return for not getting a guaranteed rate, you are likely to earn more interest over time than you will get from a fixed annuity. But indexed annuities also usually place some type of limit on the amount of interest that you can ears. There are three ways they usually do this. 

  • Participation Rate – This is the percentage of interest that the insurance company will pay you. For example, if the benchmark index rises by 10% and your participation rate is 80%, then you would be credited with 8% of interest (10% X 80%). 
  • Cap – This is an absolute limit on the amount of interest that you can earn. So if your indexed annuity has a cap of 10%, then that’s the maximum amount you can earn. If the benchmark index rises by 25%, you will still only get 10%. 
  • Spread – This sales charge is assessed against your initial earnings. For example, if the spread in your contract is 2%, then the first 2% of interest that you earn will go to the insurance company. But you will get all interest in excess of 2%, no matter how much it may be.

Indexed annuities are the newest type of annuity in the marketplace today. They offer a happy medium between fixed and variable annuities, between safety and risk. And they have generally outperformed fixed annuities over time and have even beaten variable contracts in some cases. 

Variable annuities are the riskiest type of annuity. The insurer will pay interest based on the performance of mutual fund subaccounts that invest in stocks, bonds and real estate. You can lose your principal in a variable annuity if the values of the subaccounts drop. 


Most annuity contracts that are sold today also come with optional riders that can provide further protection to investors. These riders can guarantee a set minimum rate of interest that the annuity will pay as long as certain conditions are met. They can also guarantee a minimum death benefit or increase liquidity.

Other riders can guarantee an increased payout if the annuitant has to pay for long-term care benefits. These riders come at a cost, so it’s best to think carefully about what guarantees you really need before opting for one or more of them. The average annuity rider usually costs about 1 percent of your contract balance per year. 

Back-End Surrender Charges

Virtually all annuity contracts come with a back-end withdrawal sales charge schedule. For example, a typical schedule could charge the contract holder 15% on any withdrawals made during the first year. But most annuities will also allow investors to withdraw a certain amount each year, such as 5 or 10 percent without having to pay a penalty. The charges decline steadily each year until they finally expire. But it can sometimes take up to 15 years for this to happen. 

Using Annuities Correctly

The most important thing to understand about annuities is that they are not designed to be liquid instruments. If you’re looking for a short-term investment to park some cash in for a couple of years, then an annuity is not right for you. But if you are saving for your retirement, then an annuity may be exactly what you need.

Annuities are frequently held inside IRAs and qualified plans, even though they are inherently tax-deferred. This is done to take advantage of other features in the contract that the owner considers to be beneficial. For example, a variable annuity may feature a specific group of funds that an investor wants to buy, or it may provide other money management services such as portfolio rebalancing or dollar-cost averaging. 

Bottom Line on Annuities

Annuities are unique, versatile investments that investors can use to save for their retirements. Fixed, indexed and variable contracts can help investors to grow their money on a tax-advantaged basis with varying degrees of risk. But it is important for investors to know all of the features and benefits of a given contract before investing.

Be sure to read the fine print before making a purchase. Consult your financial advisor for more information on annuities and whether they are right for you. 

Magna Life Settlements Staff

Magna Life Settlements Staff

Magna Life Settlements is the leading life settlement provider. Magna pays people cash for their life insurance policy from the convenience of their own home online. Our team has decades of financial experience, and are dedicated to helping those in need. Many people have no idea just how valuable their life insurance policy is when they surrender or lapse it, and so many policies today are just given up because of inability to pay the premiums. If you fit our criteria you may be able to receive real value for something you felt had become a burden.

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