I n the dizzying world of investments, annuities are perhaps one of the most complicated and confusing options available. Immediate or deferred? Fixed or variable? Straight-life or joint-and-survivor? The choices can confound even the most experienced investor.

Here are some questions to help you find your way through the annuity maze and determine if it's an investment that belongs in your portfolio.

What is an annuity?
An annuity is a contract between a consumer and an insurance company. The consumer invests money with the insurance company in return for a stream of retirement income.

A small percentage of people choose an immediate annuity. They hand over a lump sum to the insurance company, which immediately starts paying out an income.

The majority of annuities sold today are deferred annuities. You pay a series of premiums or invest a lump sum that grows in value over time (at least one year but usually much longer) and provides a payout at a later date.

When you need the money, you can withdraw a percentage from your annuity each year. Or you can instruct the insurer to "annuitize" your investment. That means you'll give up your principal in exchange for fixed monthly payments from the insurer for the rest of your life, and possibly a survivor's life.

Who sells annuities?
Insurance companies issue annuities, but many different financial institutions, such as credit unions, banks, insurance agents, and financial planners sell them.

What factors determine the income I'll receive?
Your return will depend on a few variables:

  • Your accumulation. How did the insurer invest your money: in a guaranteed-return instrument (a fixed annuity) or in instruments tied to the stock market (a variable annuity)? The greater the sum that has built up in your account, the larger your payments will be.

  • The age at which you start making withdrawals. If you retire early, your annuity must stretch over a longer time span. The monthly payments will be smaller.

  • The payment option you select. There are several choices available, designed for different situations.
For example, a straight-life annuity makes payments over the life of one individual, regardless of how long the person lives. If John Doe receives the first payment today from a straight-life annuity, and dies in a car accident one month later, the payments end with his death. Because of this uncertainty, a straight life annuity pays the highest income of all options, says Brian Breuel in his book "The Complete Idiot's Guide to Buying Insurance And Annuities" (ISBN 0028611136).

If you have a spouse to care for, a joint-and-survivor annuity pays an income for two lives. Once the first spouse dies, the second spouse continues receiving payments. Because it's spreading payments over a longer time period, the annuity will pay out less each month.

There are several other choices: annuities that pay a death benefit, annuities that guarantee a stipulated minimum payout, and so forth. For these added benefits, you'll pay higher premiums. To determine which income option best matches your financial needs, consult your financial advisor.

What is a fixed annuity?
"A fixed annuity provides a fixed return, usually adjusted annually," says Laura Tarbox, a certified financial planner with Tarbox Equity Inc. in Newport Beach, Calif. "Usually the insurance company will guarantee a rate of return for the first year. After that, the rate will be determined by market conditions or by the insurance company itself. There is usually a 'floor,' a minimum rate of return of 3% or 4%. The advantage of the fixed annuity is that your policy is not subject to stock market risk and fluctuations." The owner will never lose premiums paid.

Unlike other fixed-return instruments like share certificates, a fixed annuity isn't backed by the government but solely by the financial strength of the issuing insurance company. "You want to make sure it's a strong company by checking its ratings with A.M. Best, Moody's, and other services," says Gwen Reichbach, executive director of the National Institute for Consumer Education at Eastern Michigan University, in Ypsilanti.

What is a variable annuity?
"A variable annuity is like a mutual fund in an insurance wrapper," Tarbox says. Instead of letting the insurance company control the investments that create your return, you choose how to invest your money. You select a subaccount, an annuity's version of a mutual fund, in which you park your money. As with mutual funds, your return is not guaranteed; it rises and falls with the stock market. You trade the security of a fixed annuity for the possibility of higher returns with a variable annuity.

What do annuities offer to an investor?
"Annuities offer a lifetime income and tax-deferred growth," Reichbach says. "The contributions you make into the account are not taxed in the year you make them. They're taxed when you take withdrawals, usually in retirement. Most retirees have a lower income in retirement, so they're paying at a lower tax bracket when they receive payments from their annuity."

Unlike IRAs (individual retirement accounts) or 401(k) plans, annuities allow unlimited contributions. So if you need to catch up on your retirement investing, you can plug a large sum into an annuity without any restrictions.

"Annuities are for long-term retirement investing," says John Wesley, product manager for TIAA-CREF, the primary pension system for educators in the United States. "It's really for people who didn't stay in their job long enough to get vested or to accumulate a significant amount of money for retirement."

What are the tax considerations of an annuity?
"Earnings on an annuity are taxed at ordinary income tax rates, rather than the more favorable long term capital gains rate," Tarbox says. Considering that income tax rates range from 15% to 39.6%, a large share of investors will pay more taxes on an annuity than if they'd bought stocks or bonds that were taxed at the 20% capital gains rate. Also, any withdrawals made from an annuity before you reach age 59 1/2 are subject to a 10% penalty on top of the income tax you'd pay.

What are the drawbacks of an annuity?
Annuities can charge high fees that negate the financial gains of being a tax-deferred investment. "On average, it will take 10 years to 15 years of tax deferral to make up what you pay in fees," Reichbach says. The total annual fees on a variable annuity average 2.1%; a fixed annuity charges between 1% and 1.5% annually. Both top the average management fees of many mutual funds.

Annuities also impose a surrender fee, in which you sacrifice a certain percentage of your investment (usually between 6% and 9%) if you pull out your money prematurely. The surrender fee usually decreases 1% each year, disappearing only after you've held the annuity for several years.

Fees and surrender periods vary widely among companies, so shop around. "As people get smart to annuities, they'll know what to look for and start price shopping," Wesley says. "They're going to drive the industry in one direction: lower cost, lower commissions, lower fees. We're starting to see that already."

What alternatives to an annuity should an investor consider?
"Before you consider an annuity, you should maximize all your pretax or pension options: 401(k), 403(b), an IRA, a Keogh plan, etc.," Wesley says. "Then go for a Roth IRA. If you still need additional retirement income, then an annuity is the product to use."

However, don't buy an annuity within an IRA or retirement account, warns Tarbox. "You'd be paying extra to put a tax-deferred investment inside a vehicle that's already tax-deferred," she says.

Breuel recommends that you keep an eye on your portfolio's distribution. "If 80% of what you have is already tied up in tax-deferred vehicles, maybe you don't need to consider any more," he says. "You may be better off accumulating wealth outside of those places with stocks, bonds, mutual funds, or real estate."

Last, Reichbach suggests that you evaluate your SSQ: stomach and sleep quotient. "How much risk can you tolerate?" she asks. "How hands-on an investor are you? If you don't want to have to deal with decisions or much of anything, an annuity might be the right investment."

    Useful resources

    Annuities offer a
    lifetime income and
    tax-deferred growth.

    A fixed annuity
    is backed solely
    by the strength
    of the issuing
    insurance company.

    Evaluate your SSQ:
    stomach and
    sleep quotient.

Useful resources

© 2001 Credit Union National Association Inc.