What Is an Annuity? Types and Examples of Annuities

An annuity is a financial contract between an annuity company, like a life insurance company, brokerage, or an investment company, and an annuitant, the holder and eventual recipient of the annuity. The annuitant purchases the annuity contract from an issuer, either in a lump-sum payment or by making regular payments over some time. The issuer then invests the annuitant’s funds—called a premium or purchase payment—and eventually makes annuity payments on a schedule determined by the type of annuity. The US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA)—a private, self-regulatory agency—regulate annuities.

Lottery winners or recipients of cash settlements can opt to collect lifetime annuity payments rather than a large lump sum. Annuities are typically part of a retirement plan and can provide a steady income stream at a guaranteed rate for the rest of the annuitant’s life. However, an annuitant who plans to use it as retirement income should make it a part of long-term retirement planning. If they withdraw the annuity before a specific age—usually 59 ½—the additional benefits, known as riders, may lose value. Riders are optional benefits that annuitants can purchase to enhance an annuity, like the death benefit, which allows an annuitant to pass on their assets to their beneficiaries in the event of their premature death.

Most annuities also have a surrender period, usually in the first five to 10 years of the annuity. The annuitant will incur surrender charges, or fees, if they prematurely withdraw funds or cancel during this period. Early withdrawal is also subject to income tax and a possible 10 percent tax penalty from the Internal Revenue Service (IRS).

There are different kinds of annuity products available to consumers, including:

1. 1. Deferred: You can fund a deferred income annuity through regular payments or a lump-sum payment. This type of annuity then grows during the accumulation period. The accumulation is tax-deferred and then either withdrawn or distributed back to the annuitant at an agreed-upon future date. Companies disburse payments for deferred income annuities as either a lump sum or series of payments.
2. 2. Immediate: Also known as a single premium immediate annuity, these annuities allow an annuitant to receive immediate income payments as soon as the premium is paid with a lump-sum amount. Typically used to supplement the annuitant’s retirement account immediately, the purchaser cannot cancel this type of annuity.
3. 3. Indexed: Indexed annuities base their value on the financial strength of the stock market index. If the index has gains, or an increase in value, the company will credit a portion to the account, and if it experiences losses, the account value remains untouched. However, there are rate and yield caps that can limit the amount allocated to the account. Fixed indexed annuities offer both a fixed interest rate for a specific period while also basing part of its value on the stock market.
4. 4. Fixed: A fixed annuity pays a fixed rate, or guaranteed rate of return, based on the annuitant’s contributions over a specific period. Like deferred annuities, the account is tax-deferred during the accumulation phase, and fees are largely limited to surrender fees.
5. 5. Variable: A variable annuity does not offer a guaranteed rate. Instead, it shares a similar structure to an indexed annuity since its value changes based on the stock market index performance of its sub-accounts, which are a variety of investments similar to mutual funds. This type of annuity generates fund management fees, administrative fees, and surrender penalties that average 2 percent or more.

Annuities work follow several steps:

1. 1. Purchase: The annuitant buys an annuity from an annuity company, either as one lump sum or a series of payments. Depending on the type of annuity purchased, they can receive payments for a specific number of years, known as period certain, or for the rest of their lives.
2. 2. Accumulation: The period when the annuity is funded, either by the annuitant making deposits or through investments by the annuity company, is called the accumulation phase. This phase begins as soon as the annuitant makes payments to the annuity and will last for a predetermined period.
3. 3. Annuitization: When the accumulation period ends, the annuity issuer will send payments to the annuitant. The type of annuity that the annuitant purchased will determine the payments’ size, method, and duration.

There are several different examples of annuities available as investment options to the public, including:

1. 1. Defined benefit pensions: A defined benefit pension is similar to an annuity in that it guarantees specific benefits upon retirement based on salary and employment history. The employer oversees the pension, which they can pay out as a lump sum or a lifetime annuity. Since it takes the form of a deposit to a bank, the Federal Deposit Insurance Corporation (FDIC) oversees this type of annuity instead of the SEC.
2. 2. Loans: Mortgages and car loans are prime examples of simple fixed annuities. The annuitant secures a loan by making a down payment to purchase a major piece of property, like a home or vehicle. Payments are then made on a regular, pre-determined schedule, and upon completion, ownership is transferred to the annuitant.
3. 3. Social security: The federal government’s social security program is, at its core, a government-backed annuity, similar to an immediate annuity. The program provides a guaranteed stream of income for the life of retirement-age (65 or older) recipients who have paid into social security for at least 10 years.

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