What is an annuity? Annuity definition

If you are one of the many people finding themselves asking the question 'what is an annuity and how does it work?' then you have come to the right place. This page is a simple guide all about what annuities are where we define annuity with our ever so straight forward annuity definition. This is the perfect place to find out all about annuities before you speak to somebody about buying one where the pressure in on from them to make a sale out of you! An annuity is what many people use to meet their long range financial goals and once you have read about the different types of annuities on this page you will be in a much clearer frame of mind as to whether or not you need or want one, and also which of the annuities could be best suited to you.

Annuity definition

First of all we are going to let you know what an annuity is with a plain and simple annuity definition. We have tried to define annuity as best as possible here without using the long jargon words that would generally be included in an explanation from an agent or the insurance company selling the annuity to you.

So what is annuity? An annuity is a contract, or policy for want of a better word, that you the consumer take out with an insurance company. The purpose of an annuity is to reach long term financial goals that you have for retirement or even before that time in life. You pay into this contract either as a one off lump sum payment or a series of regular payments and then the insurer will begin to make payments out to you as required, this could be straight away or at a certain time in the future. The payments can be made to you or any other chosen beneficiary and it is also possible for there to be a lump sum death benefit payable if you die during the contract.

The insurance company will invest your money so that you gain money and they protect you against loss, the gains on an annuity are also generally tax-deferred. When anyone says that they guarantee to protect against loss that is all very well but remember any insurer can go out of business!

The idea of an annuity is for you to invest in order to gain wealth on your investment before the insurer pays the money you paid them back to you, with the wealth, in a series of payment where the wealth is tax deferred.

This annuity definition is what an annuity is in a nutshell. Of course there are all sorts of rules and regulations that go along with annuities such as how the money you receive is taxed and certain penalties for taking out money early, these are explained further in our next section.

There are also several types of annuities that you can purchase, for more information on these please see further down the page.

What is an annuity and how does it work?

It is not uncommon for people to ask 'what is an annuity and how does it work?' and the chances are if you have landed on this page you have been wanting to know the answer to this very same question. In our above annuity definition we have tried to explain what an annuity is as simply as possible.

In short what an annuity is, is a source of income that has tax benefits, payments to the customer from the insurance company will consist of the money already paid and also interest from investment gains. The interest element of the payment is taxable but as it is spread over the life of the annuity it is deemed as deferred. Other sources of income that you have may dry up but annuity income cannot be outlived.

While tax is deferred on earnings growth on an annuity, when withdrawals are taken from the annuity, gains are taxed at ordinary income rates, as opposed to capital gains rates. If you withdraw your money early from an annuity, you may find that you have to pay substantial surrender charges to the insurance company, as well as tax penalties too.

There are different types of annuities and how they work varies. We have provided an example of how each type of annuity works further on down the page, it is always easier to see how any financial contract works with an example.

Types of annuities

So now that we have answered the question 'what is a annuity?' and provided you with an annuity definition we are going to tell you what the different types of annuities are. You will find that there are in general three different types of annuities:

• Fixed annuities
• Indexed annuities
• Variable annuities

What we will now go on to do is explain what each type of annuity is and provide you with an example as to how they work.

What is a fixed annuity?

A fixed annuity is where the insurance company will agree to pay you at minimum or above rate, or just a flat fixed rate of interest during the period of time that your investment is growing. The insurer also agrees that the payments made to you will be a specific amount per dollar in your account. It is possible for the period of time in question to last for a certain period of time, say 25 years, or just indefinitely, so for the rest of your life. These agreements are fixed because the insurer is telling you what will happen and how much will be paid up front. There are different types of fixed annuity and it is always best to check the terms and conditions of any contract before you buy into it.

Fixed annuity examples:

So what is a fixed annuity? The below examples show how two different types of fixed annuities can work:

Some fixed annuities, often known as 'Certificate of Deposit' annuities are very easy to understand. The contract length is stated at the start and the interest rate paid is guaranteed.

Mr Carroll takes out a Certificate of Deposit fix annuity for 5 years where the interest paid is 5% for every year. He is paying $10,000 as a deposit and he can withdraw the interest of $500 each year or even monthly if he wished. At the end of the 5 years Mr Carroll would also get his deposit of $10,000 back. If he did not take any of the interest each year or month then he would have mounted up $12,762 due to compounded interest.

There are other types of fixed annuity that do not offer a guaranteed rate of interest every year. Instead they may offer an 8 year contract with a tempting 4 year interest rate of 5.5% and then the following 4 years the interest rate would change according to the current interest rates, perhaps with a minimum amount stated of 3.5%. So for half of the contract you know you are going to get 5.5% but after that you know you will never get any less than 3.5% but potentially much higher.

Mr Carragher takes out a fixed annuity for 8 years where he deposits $10,000. The first four years he is guaranteed to make $550 interest and then after that for the last four years of the contract he is going to earn at least $350 a year but this could be a lot higher. Even if interest rates are lower than 3% the minimum amount is still guaranteed.

We hope that this section has helped go some way to answering the question 'what is a fixed annuity?'.

What is a variable annuity?

If you want to know 'what is an annuity?', in relation to a variable annuity then this next section is going to give you your answer. Just like the name suggests, with a variable annuity there are a wide range of investment options for you to choose from. The rate of return that your annuity will get on your initial payment and and the amount that the regular payments that your receive will be will vary depending on the performance of the investment options that you choose at the beginning.

So why choose a variable annuity? There are a few reasons as to why you may want to purchase a variable annuity and these are generally that you want more potential for growth as the rates are not fixed, you happy to take bigger risks with your money and there is more flexibility than the bog-standard fixed annuity offers.

You must realise that due to the variables on this type of annuity you need to make informed choices because if your variable annuity does not perform as expected this is largely down to your own investment decisions when choosing the variables at outset.

For more information visit: http://www.sec.gov/investor/pubs/varannty.htm

There are higher fees and charges for taking out a variable annuity and this is why you really need to know what it is that you are investing in before hand so we always suggest speaking to a financial agent that provides free advice.

What is an indexed annuity?

Now we come to the section that answers the question what is an indexed annuity? This is going to a popular part for many people want to what a annuity is. With indexed annuities an insurance company will normally offer a guaranteed minimum return, so even if the stock index of the annuity performs badly, you will not suffer such a big loss. However, it is also common for the yield to be lower than expected due to potential limitations on the upper limit of interest that can be earned on an indexed annuity, plus there can be free-related deductions.

An example of an indexed annuity:

Mr Adam's indexed annuity is based on the ND 500, and this earns 10% one year, the indexed annuity's terms and conditions state that the fees for the contract are 2% and the max cap on the return is 9.5%, this means that Mr Adam only receives a total of 7.5% return for this year.

In the example that may seem unfair that there is a limit and that there is a deduction but the chances of a much higher return are available on these annuities than fixed annuities, of course there are risks though as this is directly linked to the stock market.

We really hope that we have been able to help you understand what an annuity is with not only our annuity definition where we have tried to define annuity as simply as possible, but also through our explanations of the three main types of annuities.

More than what is annuity?

There is so much more to our website that what an annuity is so please take the time to take a look around at the free information that we have on offer about many other different types of insurance policies. As we have said an annuity is what many people find useful for their long term financial goals, but this does not apply to everyone. We hope that our annuity definition has been useful to you and that you know now what an annuity is and how it works. If you are interested in purchasing one of the types of annuities that we have mentioned on this page then we urge you to look around before making a final decision, it is also generally better to buy online as many insurers will offer better rates and going through an agent may end up costing you a fee.

We have endeavored to define annuity as simply as possible through our definition of annuity, but if you do have any further questions on what is a annuity then it could be a good idea to speak to an insurance agent or one of the many insurance companies directly.