The annuity is a complex and often misunderstood retirement investment with characteristics of both life insurance and investments. The word annuity means stream of income and an annuity investment is intended to create retirement income over the life expectancy of the owner. The mechanics as to how the annuity produces the income benefit varies widely.
Traditionally, the annuity “insurance” element was a guarantee that your heirs would receive the original investment as a death benefit. These guarantees have evolved to include guaranteed minimum growth in the contract value during the accumulation phase and guaranteed income for life. These “living benefits” are subject to a whole host of restrictions and limitations and are expensive to purchase.
The insurance component of an annuity does create a nice tax benefit – income tax deferral on the earnings and growth of the annuity contract during the accumulation phase. Withdrawals from an annuity are always taxed as income first.
All annuities are manufactured by life insurance companies. The principal guarantees are only as good as the financial strength of the sponsoring insurance company, so it important to select contracts offered by carriers that are financially sound with good credit ratings.
There are three types of annuities. A fixed annuity is a straightforward contract paying interest/income either on an immediate or deferred basis. The variable annuity is more complex, offering guaranteed living benefits and growth-oriented investment options. The third category, the equity indexed annuity, is a complicated hybrid of the first two.
An annuity can complement a balanced retirement plan by creating a guaranteed stream of income to your retirement income plan. At the same time, they are expensive, inflexible and subject to unfavorable income/death tax treatment, which could render them unsuitable for some investors.
