Understanding Annuities: What is an Annuity?

Annuity Objectives ^Top

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Did you know that an annuity can be used to systematically accumulate money for retirement purposes, as well as to guarantee a retirement income that you cannot outlive?

In planning for financial security in retirement, an annuity can help satisfy two basic objectives:

• To accumulate retirement assets on a tax-deferred basis. If you're already contributing the maximum to IRAs and any employersponsored retirement plans and need to save more for retirement, a deferred indexed annuity may be the answer to your retirement savings need.
• To convert retirement assets into an income that you cannot outlive. On the other hand, if you're near or at retirement, an immediate income annuity can be used to convert existing retirement assets into a lifetime income.

What is an Annuity? ^Top

An annuity is a long-term savings plan that can be used to accumulate assets on a tax-deferred basis for retirement and/or to convert retirement assets into a stream of income.

While both are insurance contracts, an annuity is the opposite of life insurance:

• Life insurance provides financial protection against the risk of dying prematurely.
• An annuity provides financial protection against the risk of living too long and being without income during retirement.

There are two basic types of annuities, depending on whether you need to accumulate assets for retirement or whether you're at or near retirement and interested in creating a lifetime retirement income:

Deferred Annuities

A deferred annuity has two distinct phases: the accumulation phase and the income phase.

• During the accumulation phase, you contribute premiums to the annuity, where they accumulate on a taxdeferred basis until needed for income purposes.
• During the income phase, the value of the annuity is converted into income payments.

Immediate Income Annuities

An immediate income annuity is purchased with a single premium and income payments begin immediately or shortly after the premium is paid.

How are Annuity Premiums Invested? ^Top

Depending on your investment objectives and risk tolerance, there are a variety of ways that you can choose to invest your annuity premiums:

1. Fixed Interest Annuities
   A fixed interest annuity pays a fixed rate of interest on the premiums invested in the contract, less any applicable charges. The insurance company guarantees* that it will pay a minimum interest rate for the life of the annuity contract. A company may also pay an "excess" or bonus interest rate, which is guaranteed* for a shorter period, such as one year.
2. Variable Annuities
   During the accumulation phase of a variable annuity, premiums less any applicable charges are placed in a separate account of the insurance company, where the annuity owner can invest them in one or more stock and bond subaccounts. During the income phase of a variable annuity, the amount of each income payment may be fixed and guaranteed*, or it may be variable, changing with the value of the investments in the separate account.
3. Indexed Annuities
   An indexed annuity has characteristics of both a fixed interest annuity and a variable annuity. Similar to a variable annuity, the insurance company pays a rate of return on annuity premiums that is tied to a stock market index, such as the Standard & Poor's 500 Composite Stock Price Index. Similar to fixed interest annuities, indexed annuities also provide a minimum guaranteed* interest rate, meaning that they have less market risk than variable annuities. Since the minimum guaranteed interest rate is, however, combined with the interest rate linked to a market index, indexed annuities have the potential to earn returns better than fixed interest annuities when the stock market is rising.

A Closer Look at Equity-Indexed or Indexed Annuities ^Top

The indexed annuity is a hybrid of the fixed interest annuity and the variable annuity:

• The insurance company pays a rate of return on your annuity premiums (less any applicable charges) that is tied to a stock market index, such as the Standard & Poor's 500 Composite Stock Price Index.
• Similar to a fixed interest annuity, an indexed annuity also provides a minimum guaranteed* interest rate, meaning that it has less market risk than does a variable annuity.

An indexed annuity is an insurance contract and not an investment in the stock market. Indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. Any interest payable in excess of the minimum guaranteed* interest rate is determined by a formula contained in the annuity contract. This formula is determined by a variety of indexed annuity contract features, including:

• Indexing Method: There are different methods used to determine the change in the relevant index over the period of the annuity. The indexing method used will impact the amount of interest credited to the contract.
• Participation Rates: How much of the gain in the index will be credited to the indexed annuity? If, for example, an indexed annuity has an 80% participation rate, the annuity will be credited with only 80% of any gain experienced by the index.
• Spread/Margin/Asset Fee: An indexed annuity may contain a spread/ margin/asset fee instead of, or in addition to, a participation rate. If, for example, an indexed annuity has a 3% spread/margin/asset fee and the index gains 9%, the interest credited to the annuity will be 6%.
• Interest Rate Caps: Some indexed annuities contain a cap or upper limit on the amount of interest the annuity will earn. For example, if the cap rate is 10% and the index linked to the annuity gains 12%, only 10% will be credited to the annuity.