Let’s face it - annuities are a bit difficult to understand. You may work in public education and have an annuity, or you may have purchased an annuity from a financial advisor. Either way, understanding what an annuity is and how it is different form an IRA, and how it relates to a 401k and 403b, is important to know! #investing #stockmarket #stock #money #personalfinance #saving

I would imagine most people responding when asked about annuities would be about the same as the response from Ron Burgundy.

Annuity?  Como what?  Is that even English?  Baxter, you speak Spanish, what the hell is an Annuity?

AnnuityPhoto Credit: Flickr

Annuity. What a strange word.  Where could the origin of the word annuity possibly be from anyway? Italy? France? Russia? The Netherlands?  Probably not from China or Korea, maybe San Diego?  Whale’s vag……ok ill top the Ron Burgundy jokes there.

To most people, annuities may as well be written in a foreign language.

The problem with the word annuity is that it describes only a small part of an annuity as its modern day financial instrument.  The word annuity is technically defined as

“A fixed sum of money paid to someone each year, typically for the rest of their life”.

While annuities have this feature attached to them, many annuities are not purchased solely for this feature.

I would personally define an annuity as a financial contract between an insurance company and an individual which has tax advantages as well as some type of death benefit advantage and a feature which allows annuitization of their money.

Are you confused yet by all of that jargon?  Trust me, I was too when I first started learning about these intangible enigmas.  Keep reading and I will explain what that means.

Young man is shouting for doing all the works in home

An annuity is a contract

  • This is one of the most confusing aspects of annuities.  An annuity is not a piece of equity like a stock, nor a debt instrument like a bond.  It is a contract between an insurance company and an individual.  The contract states provisions the insurance company is obligated to abide by via the language of the contract.  Whether it be guaranteed investment rates, guaranteed minimum income streams, death benefits, minimum interest rates etc..

Annuities have special taxation

  • There are two ways to purchase an annuity.
    • Non-qualified – a non-qualified annuity will be taxed differently than a qualified annuity.  A non-qualified annuity uses after tax dollars and is tax deferred.  Non-qualified annuities distributions are taxed by the gain, not the entire amount distributed.
    • Qualified – a qualified annuity can be used inside a qualified account in which the money is tax deductible or the source of funds comes from tax deductible accounts such as an IRA, 401k, 403b etc..  Qualified annuities are income taxable when money is distributed.

Many annuities have some type of death benefit feature

  • Many annuities as contracts have provisions that protect the principal amount allocated to the account as a death benefit.  Bet that sentence confused you.  Here is an example, if someone allocates $100,000 to an annuity and the investment declines to $50,000.  If that person dies, the beneficiary of the annuity will receive the principal allocated to the annuity, which in that case would be $100,000 even though the account balance is $50,000.
  • Stepped up death benefit riders are also available to add to some annuities.  This rider will usually lock in the amount of the account at it’s highest value on a certain date.  If your $100,000 annuity grew to $150,000 that amount can be locked in.  If the annuity lost $30,000 the following year the beneficiary of the annuity will inherit the $150,000 which was locked in, not the $120,000 (account value after the $150,000 account lost $30,000)

Fight betwen husband and wife, mad woman, confused man

Annuities allow for annuitization

  • Annuitization is the the process of creating up to a lifetime periodic income payment.  A pension plan payout is just like an annuitization.  It is a constant stream of money paid to the participant in the pension.  Jut like in a pension, an annuity allows different options for payout of the income stream.
  • Different income streams include
    • Life income – this income stream will last the annuitant’s entire life.  When that annuitant dies, the income will stop.
    • Life income with cash refund – this income stream will last an annuitant’s entire life.  If the annuitant dies before the entire principal amount has been paid, the insurance company will refund the remaining amount.
    • Life period certain – some annuitants may only want income for a specific number of years.  After the final year ends, the contract will pay no more income.  For example, maybe an individual wants a guaranteed income stream for 10 years, after the 10th year, the income stream will stop.
    • Joint life – many times with spouses, the annuitant doesn’t want the payout to stop if they predecease their spouse.  A spouse may outlive the annuitant by many years, so the joint life option will allow a guaranteed income stream for both spouses for their lifetimes.
    • Joint life period certain – if you combine the joint annuity with the period certain, you guessed it, you get the joint life period certain.  This is used if an annuitant wants a period certain annuity, eg. a 10 year payment, but wants the guarantee their spouse will continue to receive the payment if the annuitant dies before the 10 years ends.

Some popular annuity types include the following:

Immediate annuity

An immediate annuity can be referred to as a single premium immediate annuity (SPIA).  Allows the lump sum deposit of money to an insurance company in order to receive a guaranteed income stream for a certain amount of years or end of life.

An example of some current SPIA rates if $100,000 was allocated to a single premium immediate annuity (SPIA) for a 65 year old male:

  • Life Income$495 / month for the annuitant’s entire life.
  • Life Income with period certain 10 years$483 / month for annuitants entire life, if annuitant predeceases spouse, will continue paying up to the 10th year from when contract was opened.
  • Life with cash refund$450 / month for annuitant’s entire life and if annuitant dies before the entire $100,000 has been paid back, the remainder of the principal will be paid to the beneficiary until the $100,000 is met.

Here is an example with joint annuitants both spouses 65 years old:

  • Joint and survivor life annuity$417 / month for the lives of both annuitants.
  • Joint and survivor life annuity with period certain 10 years$416 / month for lives of both and will continue paying to beneficiary up to 10 years after contract is purchased.
  • Joint and survivor life annuity with cash refund$411 / month and if the entire $100,000 is not paid back before the death of both annuitants, the payments will continue until the $100,000 is paid to the beneficiaries.

Fixed annuity

Tax deferred contract which pays a fixed interest rate or a minimum fixed interest rate and the ability to turn on an income stream.  Here is an example of a current fixed annuity for $100,000

  • First year interest rate 2%
  • Second year interest rate 1%
  • Minimum interest rate .5%
  • Surrender period 7 years starting at 8% and declining for 7 years
Account Balance:
  • Year 1 – $100,000 @ 2% = $102,000 end of year → amount available after surrender charge of 8% $94,656
  • Year 2 – $102,000 @ 1% = $103,020 end of year → amount available after surrender charge of 7% $95,594
  • Year 8 – $105,621 @ 1% = $106,149 end of year → amount available after surrender charge of 0% $ 106,149
Death Benefit:
  • Year 1 – $102,000
  • Year 2 – $103,020
  • Year 8 – $106,149

As you can see, in a low interest rate environment, the fixed annuity is looking sweet!  Yeah, just kidding, it sucks.

Variable annuity

Tax deferred contract which allows the owner to invest in mutual fund sub accounts and attach riders to contract.  Will likely have a death benefit that is no less than the net amount allocated to the annuity.  Has the ability to turn on an income stream.

Here is an example of a $100,00 deposit into a variable annuity with that made 5% annually with a rider called a guaranteed minimum accumulation benefit (GMAB).

  • Investment – 60% equity mutual fund 40% bond fund
  • Riders – GMAB (many variable annuities companies have many different rider options.  This is just one I randomly chose).
  • GMAB duration = 12 years (you are locked into your highest account value over a 12 year period)
  • Surrender charge = 7% declining for 7 years
  • Separate account expenses = 1.3%
  • GMAB charge = 1.4%
  • Mutual fund expenses = 1.2%
  • Yrs 1 – 7 = 5% net annual rate of return
  • Yr 8 =  -20% return
Account balance
  • Year 1 – $100,000 @ 5% = $105,000 end of year → amount available after surrender charge of 7% $97,650
  • Year 2 – $105,000 @ 5% = $110,250 end of year → amount available after surrender charge of 6% $103,635
  • Year 7 – $134,009 @ 5% = $140,710 end of year → amount available after surrender charge of 0% $140,710
GMAB Rider – Assuming a market decline of 20% on year 8
  • Year 7 – $140,710 @ 5% = $140,710 end of year
  • Year 8 – $140,710 @ – 20% = $112,568 end of year → GMAB balance = $140,710
    • This means the guaranteed minimum balance would be $140,710, within a 12 year period.
Death Benefit
  • Year 1 – $100,000
  • Year 2 – $105,000
  • Year 7 – $140,710
  • Year 8 – $112,568

You may or may not like the variable annuity.  Just remember this puppy costs a pretty penny.  Check out how much you are paying in fees for this annuity: 3.9% annually.  It’s really difficult to eek out a rate of return with the weight of a 3.9% annual expense, let alone a high rate of return.


Merlin’s beard annuities are difficult instruments to understand!  I hope this helped.


Who out there likes annuities?  Who thinks they are too intangible enigma-ish?  Who just doesn’t understand them?  Who loves them?


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Riddler vs. Edward (264/365)