There are few people who haven’t at least heard the word annuity. But I think that there are few people who actually understand what an annuity is. I think it is important to understand what an annuity is because there is a very large effort in our country to get people to invest their money in annuities and a lot of misinformation, both for and against, such an action. From the beginning I will let you know that I believe there are annuities available that would be good for some people in certain situations – in fact that would be the best choice that they could make. However, I also believe that way too many people are sold annuities that would be much better served in other ways, as well as many annuity products that are not beneficial to anyone.

In the Beginning

To begin, the word annuity means a series of payments at set intervals for a defined amount of time. You most commonly find this term (when it comes to income) in lottery payments, pension payments and insurance products. When it comes to the insurance products the word annuity has come to mean a lot of other things in addition to the definition that I gave. However, that definition is the underlying basis of the product.

Insurance Annuities

The fact that annuities come from insurance companies is significant. When you purchase an annuity you are really purchasing insurance on your money. Just like you insure a car or a house in case of loss, you are insuring your money in case the value goes down. If it does, the insurance company makes up the difference, to one extent or another. And, just as with any other form of insurance, for that protection you are paying premiums or fees as you go along in order to get that promise of protection. The fees are taken as a percentage of the amount of money that is being protected, or the total value of the investment.

To continue the analogy, with car and home insurance there are things that you automatically protect and then other things that you can add to protect as well. Each time you increase the level of protection you also increase the fees that you pay for that protection. So, I may choose not to protect my car against theft or chipped windshields, but you may think it is worthwhile. All else being equal, you will pay more for that protection than I will.

What Kind of Protection Can I Get?

There are three basic things (with tons of variations) that annuities can protect against. I will discuss these options further in subsequent installments. For now I will give you the basics.

Income Protection
Annuities got their name from this protection feature. The idea is to protect you against a shortfall in future income. In essence, the insurance company takes your money and, in turn, promises to pay you a certain amount for a defined amount of time. That time period might be 5 years, 10 years or even a promise that they will pay that amount for as long as you live. The alternative is to have your money elsewhere and take the risk due to market fluctuations, inflation or theft (if you put the money in your mattress). Like I said before, there are a bunch of variations of this protection feature, but this is the basic idea underlying all of them.Principal Protection -

In this case the protection that you are purchasing is a promise that no matter what happens in the investment world (including where your money is invested) you will not lose money. It may not go up in value, but it won’t go down either. With this promise there are also rules that you have to abide by in order to receive the promise. Usually one of the rules is that you can’t withdraw the money for a certain amount of time. Break the rules and all bets are off.Inheritance Protection -

This type of protection is usually called a death benefit. It is very similar to the principal protection, except that there is usually no time frame and no extra rules. It is basically a promise that if you die your heirs will receive at least an amount equal to what you put in, or more if the account has a greater value. This feature is an automatic part of almost every annuity that I have seen, but there are a few exceptions.

Taxes and Penalties
One more feature of an annuity that is often touted by those who sell them is the tax benefits. The IRS gives to annuities many of the same rules as they do to IRAs or 401(k)s. You will not receive a tax deduction for investing in an annuity (unless it is also an IRA or the like). However, the money grows in the account tax deferred – meaning you won’t pay any taxes on the growth while it remains in the annuity.

Along with the tax benefit also come the consequences and possible penalties. First, when you to pull money out of an annuity you will be taxed on the growth. Second, if you remove money before the year in which you turn 59 ½ you will also have to pay an additional 10% penalty. This is the case even if you don’t use the money but only move it to a different type of investment, like a mutual fund (for non-qualified money only).

To top it off, nearly every annuity product has its own penalty schedule and rules for how and when you can take your money out. There is usually a period of years after the initial investment where you have a penalty assessed on the entire principal for taking the money out early. That number of years varies greatly, but I usually see four years at the low and I have seen as many as fifteen years at the high end. The penalties tend to range from 8 to 10% for the first year, and then slowly move down over the remaining years.

A Few More Quick Things

All of the promises and guarantees are based on the insurance company’s ability to pay. Be careful which company you are choosing. Second, should you choose to annuitize (start that guaranteed income stream) that is almost always a permanent decision. Usually there is no turning back once it starts.

In the following three parts I will discuss in more detail the annuity options that are available in the market today. Whether one or another is right for you depends completely on your personal situation and on the particular product that is being offered. I will only discuss the general details of each type of annuity.

* This article is commentary on basic principles. In no way should the things said in the article be construed or interpreted to be advice for your specific situation. Before making any financial decision you should consider all factors and consult with a professional. 

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