What are annuities?

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An annuity is a contract between you and the insurance company. It represents the company’s promise to pay you a set amount on a periodic basis for a set period of time based on the money you invest. The upfront cost averages around 2 percent of the annuity amount. Annuities come in three broad subclasses: fixed, variable and indexed.

Fixed annuity: A fixed annuity is a low-risk, interest-based investment vehicle, similar to a bank CD, that is designed to grow at a set interest rate and provide an income stream in retirement. Typically, you make a single upfront payment of $5,000 to $1 million at a fixed rate and cannot add to the same annuity. Your principal and earnings are guaranteed by the insurance company and, in the event it fails, by your state’s guaranty fund.

Fixed annuities are more liquid than CDs, but surrender fees for early and lump-sum withdrawals can be severe, including a 10 percent IRS fine for withdrawals before age 59½. This product is suitable for investors looking to avoid market volatility.

Variable annuity: A variable annuity is a security instrument similar to a 401(k) account with an insurance wrapper that provides an income stream in retirement. Money invested in a variable annuity, either upfront or over time, flows into subaccounts that closely mirror mutual funds. Annuitized income payments will vary depending on portfolio performance. This product is appropriate for investors who desire market exposure and don’t mind paying a 3 percent to 5 percent annual fee, which includes mortality and risk expense, a portfolio management fee and living benefits as well as other optional riders.

Indexed annuity: An indexed annuity is a hybrid of fixed and variable annuities in that its credited interest rate is tied to the performance of an equity index such as the Standard & Poor’s 500 index. An indexed annuity offers minimum guarantees for credited income and interest and limits exposure to index gains and losses. Indexed annuities are aimed at investors who are willing to trade some income security for limited market exposure.

Funding options: With an immediate annuity, you invest a lump sum and immediately begin to receive income payments. (See the story about immediate annuities under “More On Annuities.”) With a deferred annuity, you make payments over time, called the accumulation phase, until you choose to draw income. (See the story about longevity insurance under “More On Annuities.”)

Tax treatment: Investment gains inside of an annuity accumulate and compound tax-deferred, but the income it produces is taxed as ordinary income, not capital gains. The principal can be treated as a return of capital.

Variable annuity options

The following guarantees may be added as riders to a variable annuity contract to address specific needs such as longevity (outliving your money), liquidity (access to your money), estate planning (passing your money on) and inflation. These options usually involve an additional annual fee; cost-range estimates courtesy of Towers Perrin (now Towers Watson), a professional services firm.

Guaranteed minimum income benefit, or GMIB, guarantees that when annuity payments start, you’ll receive a minimum set amount based on a calculation of the future value of the annuity at the time you sign on. This feature is designed as a hedge against market losses. For instance, if your GMIB is set at $2,000 per month but your portfolio drops to where the benefit amount would be below that, you would still receive monthly payments of $2,000. Additional cost: 50-75 basis points.

Guaranteed minimum withdrawal benefit, or GMWB, entitles you to withdraw a fixed percentage of your premiums each year until you’ve recovered your total investment. This allows you to protect against losses that have already hit your portfolio while still benefiting from market exposure. For instance, say you had $75,000 invested, but market downturns have reduced its value to $50,000. If you’d purchased a GMWB at a rate of 10 percent, you would be allowed to withdraw $5,000 (or 10 percent) each year until you’ve recovered your entire $75,000. Additional cost: 45-65 basis points.

Guaranteed lifetime withdrawal benefit, or GLWB, guarantees that you can withdraw a minimum amount throughout your lifetime without having to annuitize. In most variable annuities, you can either take regular distributions or face steep fees for taking a lump-sum payment. This option allows you to take out a specified percentage of your invested capital without having to annuitize or pay the fines. Additional cost: 50-60 basis points.

Guaranteed minimum accumulation benefit, or GMAB, offers a hedge against market downturns by ensuring you’ll receive a guaranteed level of annuity payments regardless of the performance of your annuity. Here’s how it works: Say you have a $250,000 annuity with a GMAB that guarantees the greater of the actual value or what it would be based on 6 percent compounded annually. Fast forward 10 years. Your annuity is only worth $300,000 due to poor market performance. Your GMAB would allow you to annuitize $447,712 (the growth of $250,000 at 6 percent compounded for 10 years), or nearly a third more than you would have had without it. Additional cost: 25-75 basis points.