If you’re like a lot of people, you’ve either heard the word “annuity” or read it somewhere, usually in an advertisement on TV or in a magazine.  They never really say what an annuity is but they sure make it sounds good.  So, what exactly are they talking about?  That’s a good question because they could be talking about any one of a number of things that all fall under the term “annuity”.

First things first.  This issue we’ll talk about what fixed annuities are and how they work.  In the December/January issue, I’ll go over variable annuities and how they work and finally in the February/March issue I’ll go into more detail about when you may want to consider an annuity and when you should not use an annuity.  So here we go.

What exactly is an annuity?
 
If you try to do a search online for annuities, you're going to find a lot of different definitions.  Here are just a few of them:

- A regular income stream paid to an individual from a lump sum investment, usually for the purposes of retirement income.

- A series of equal amounts to be received or paid at the end of equal time intervals.

- A form of contract sold by life insurance companies that guarantees a fixed or variable payment to the annuitant at some future time, usually retirement.

Is your head spinning yet?  I can see why.  To help us understand an annuity, let’s look at a simplified example of a fixed annuity…an event we all know about and hope to experience - the winning of a $1,000,000 Lottery Prize.  Let’s say you win this $1,000,000 lottery prize.  The lottery takes your $1,000,000 and uses it to buy an annuity that will pay you $67,000 a year for 20 years.  This is a fixed annuity.  In fact, it is a Single Premium Immediate Annuity.  The immediate part means you start receiving the payment right now.  The single premium is the $1,000,000 value that the lottery paid for you. (Of course they didn’t actually pay $1,000,000 but that’s another story for another time.)  The annuity part is how long the payments last - 20 years, and the fixed part is the amount of the payment - $67,000 a year.  So you would receive $67,000 a year for 20 years and then what? And then, you would get nothing because the annuity was only for 20 years. 

Could you do an annuity that lasts longer?  Sure!  You probably could have chosen payments for your lifetime.  The payments would be smaller but they would never stop as long as you lived.  It all comes down to how long you want the payments to last in an immediate annuity.

OK, but aren’t there annuities that you don’t get payments from?  Yes. Some Fixed Annuities are similar to Bank Certificates of Deposit (CD) in that they pay interest for a specific period of time.  For instance, you can get a 5 year CD from a bank and a 5 Year Fixed Annuity from an insurance company.  They both invest the money in bonds and pay you part of the interest they earned. They keep some of that earned interest for themselves (profit), some of it goes for their expenses and the rest is credited to your CD or Annuity account.  At the end of the term (5 years) you get your money back plus the interest it earned.  In the fixed annuity world, these are called Single Premium Deferred Annuities. It’s deferred because you aren’t getting any payments right now. In the fixed annuity, the money grows tax deferred and you don’t pay taxes on the interest earned until you take it out.  In a CD, you pay taxes on the interest earned every year.

Does my age matter with a fixed annuity?  Yes!  If you are under the age of 59½ and you take money out of a fixed annuity, not only will you get hit with the income tax on your earnings but you will also get hit with a 10% penalty because of your age. 

It is important that you understand what you are buying and what problem you are trying to solve – be it lifetime income, safety of principal, tax deferral, or death benefit - before you buy.  Fixed annuities can be great in the right circumstances but be sure your circumstances warrant the extra expense of an annuity.