What is an annuity?

The term “annuity” is about as precise a descriptor as the word “vehicle”.

Just as trucks, buses, cars, and motorcycles are all types of vehicles, annuities come in a variety of forms as well. While annuities have a reputation for jargon and complexity, our goal is to simplify the world of annuities down to what is important.

At their core, all annuities are simply contracts that transfer risk from an individual to an insurance company, all within a tax-advantaged wrapper. In turn, the insurance company must make payouts to that individual (or their designated beneficiaries) in accordance with the terms of the contract.

The complexity comes from the many possible combinations of payment, interest, and payout arrangements – resulting in common annuities types including income, fixed, and variable annuities, each of which can serve a different purpose in an investment portfolio. We’ll first cover common benefits of annuities before taking a deeper look at commonly available annuities on the market.

Benefits of annuities

All annuities offer a few, core benefits:

Transfer of risk to an insurance company: Insurance companies are one of the few entities within financial services that are legally able to provide guarantees, and so an annuity contract can be written to provide benefits like guaranteed income for life or guaranteed principal protection.
Tax-advantaged growth: The owner or their beneficiaries are able to defer tax payments on any gains until the money is withdrawn, income payments begin, or the death benefit is paid to the beneficiary.
Simplified wealth transfer: Any applicable death benefit will pass directly to the designated beneficiaries, avoiding probate, if the owner passes away.
The option to annuitize: The owner can convert the contract value of any annuity into a guaranteed steady income stream either for a specific period of time or for life. Confusingly, while the ability to annuitize is a common feature of all annuities, it is relatively uncommon to annuitize many types of annuities.

The unique characteristics of annuities can open the door to improved portfolio construction, increased peace of mind, and, ultimately, better client outcomes, in turn helping advisors to deepen relationships with clients and grow their practices.

Annuities can help advisors differentiate their practices by bringing new options to client portfolios, opening up new opportunities for tax optimization planning, and unlocking powerful behavioral benefits.

Types of annuities

By combining different payment, interest, and payout arrangements, insurance companies have created many types of annuities. Different annuity types can be used to meet a variety of investment and risk management needs.

Income annuities
Income annuities provide a guaranteed stream of income for life, similar to a pension or social security. Income annuities are commonly used by clients to protect against the risk of outliving their savings, and may be either “immediate” – meaning, the income stream begins as soon as the contract becomes effective – or “deferred” – meaning the income stream begins at a later date. Income annuities are what often come to mind when people hear the word “annuity.”

Fixed annuities
Fixed annuities, also known as multi-year guaranteed annuities (MYGAs), earn a fixed, predetermined rate of guaranteed interest over a specific time period – often two to seven years. In many ways, they are conceptually similar to CDs, but instead of being issued by a bank, they are a contract between an individual and an insurance company. MYGAs offer complete principal protection – they won’t go down in value unless funds are withdrawn. Both the interest rate being paid and principal protection is guaranteed by the insurance company. With a MYGA, investors can insulate a portion of their portfolio from all market volatility. This can be especially useful for eliminating Sequence of Return risk for those just retiring, when market dips can have an outsized, long-term negative impact on the portfolio. Read more about MYGAs here.

Fixed Indexed Annuities
Fixed Indexed Annuities (FIAs) offer the potential for growth based on the performance of a market index (like the S&P 500) while still providing the same principal protection as a MYGA. To provide a simplified example, an FIA that tracks the S&P 500 might increase in value with an increase in the S&P 500 up to a maximum of 12% return in a given year – i.e. if the S&P 500 increases by 13%, the investor is capped at 12%. But if the S&P 500 has a negative return, the investor will never lose money, providing the investor with complete principal protection.

Registered Index Linked Annuities
Similar to an FIA, Registered Index Linked Annuities (RILAs) also provide growth based on the performance of a market index, but only provide partial protection from losses. In return for that lower protection, the growth potential can be greater than with an FIA.

Variable Annuities
Variable Annuities (VAs) offer maximum growth potential, with returns based on the performance of the underlying sub accounts, but zero downside protection. Like all annuities, returns are tax deferred.

Summing it up

As we’ve reviewed, an annuity is simply a contract put in place between an individual and an insurance company. While all annuities have certain shared characteristics – such as their tax-deferred nature and option to annuitize – in practice, different types of annuities bring dramatically different benefits to purchasers, ranging from guaranteed lifetime income to a fixed-rate instrument with complete principal protection.

In addition, annuity contracts can often be modified with a variety of different “riders” and benefits, complicating things further – which we will cover in future articles.

Annuities can solve core challenges facing certain investors today, and may warrant a closer look for many investors. With that said, it’s important to look beyond the label and understand the exact features of annuity and how it fits into any holistic financial plan.

What is an annuity – and why one may work for you