A Wealth of Knowledge - Winter 2012 Issue - The Basics of an Annuity Contract Used for Retirement


In its basic form, an annuity contract is a written agreement between a customer and a financial institution, usually an insurance company.  There are several variations of annuities that can also include life insurance as a rider to the annuity contract.  Annuities may grow tax deferred and, if used properly, can play a role in one’s overall retirement plan.


There are three basic types of annuities: fixed annuities, indexed annuities, and variable annuities. These annuities have the same basic annuity structures, but have different levels of potential returns and risk due to their various features.

Deferred fixed annuities
are designed to provide a steady stream of income based on the customer’s original investment in the accumulation phase plus interest.  A fixed annuity can be the most appropriate type of annuity for individuals who are risk averse, since the annuity contract agrees to pay a specified interest rate(s).  The interest rate paid over the life of the fixed contract can vary, but will not go below the minimum guaranteed rate which is established when the contract is purchased.  The customer will receive income for the term defined in the contract, which can be a specific number of years, their lifetime, or a combined lifetime that includes their surviving spouse (which would reduce their benefit).  One tradeoff of a fixed annuity is since the interest rate is guaranteed, the rate may be materially less compared to the potential return of a diversified portfolio of equities and fixed income properly invested over long time periods.  During times of low interest rates, as we are in today, the rates offered for fixed annuities are in the low single digits.  The low interest rates currently offered could adversely impact one’s retirement plan as it is possible these rates may not keep up with the rate of inflation in future years.  A fixed annuity purchased in the past during a high interest rate environment can be more attractive in today’s low interest rate environment.

Indexed annuities have the potential to provide greater returns than a fixed annuity by having the contract’s return linked to the performance of an equity index.  These annuities usually have a guaranteed minimum to help limit the downside to the customer if the linked index performs poorly.  However, contracts may also state a maximum allowed return to limit the insurance companies’ liability if the index returns are too high.  Indexed annuities are riskier than fixed annuities since future cash flow may vary and the guaranteed minimum may be less than the rate offered on a fixed annuity.

Variable annuities are the most complicated type of annuity. Variable annuities are securities wherein an insurance contract is typically invested in one or more money managers or mutual funds chosen by the customer from a pre-defined list.  The list typically includes specific investments in equities, fixed income or cash/cash equivalents. The monthly payments during the distribution phase generated from this annuity are dependent on the performance of the underlying investments.  Variable annuities may have an optional death benefit as a separate rider for an additional cost.  There are other riders that can be purchased; however, this will increase the cost of the contract.


The annuitant can elect one of several options when benefit payments begin.  Typical choices include monthly payments, quarterly payments, annual payments, or a lump-sum distribution.  In addition to choosing the frequency, the type of payment is important as well.  One can choose a single life annuity, joint and survivor annuity, or a period-certain annuity (payment over specific number of years).


Annuity contracts grow tax deferred. All annuity distributions from a pre-tax retirement plan are taxed as ordinary income.  Annuity distributions from Roth IRAs and Roth 401(k)s are not taxed (subject to Roth distribution rules).  If a lump sum distribution is taken from an annuity purchased outside of a retirement account, only the portion attributed to the accumulated gain is taxable; the remaining portion is a return of principle.  Similarly, if periodic payments are received from an annuity, (assuming it was not funded with pre-tax dollars in a retirement account) a portion of the payment is treated as a return of principle.  The remaining portion considered a gain from the annuity is taxed as ordinary income.  One should also note there is a 10% tax penalty generally for non-qualified early withdrawals before age 59 ½ on the taxable portion of tax deferred annuities.


In our opinion, purchasing an annuity contract for retirement should not be done until contributions to retirement accounts have been maximized.  Retirement accounts such as a 401(k) plan or IRA are tax-deferred.  Generally, the fees in a 401(k) plan or an IRA account are substantially less than fees charged in annuity contracts. 

If a customer decides to surrender an annuity contract (or end it early), there is a separate “surrender fee,” which is typically a percentage of the initial investment during the surrender period. The surrender fee decreases the longer the customer holds the annuity. For example: If a customer wants to surrender their annuity and their contract has a ten-year surrender fee, if he surrenders within the first year he will be charged 10%.  If he surrenders in the second year he will be charged 9%, and so on.

Other fees to consider include a “mortality and expense risk charge” for variable annuities. This fee is charged to guarantee a survivor’s benefit or to cover an annuitant’s prolonged distribution beyond normal life expectancy.  There will also be additional administrative fees or underlying fund expenses for money managers/mutual funds used in variable annuities.  One should also be aware there may by commissions paid out of their contract to those that are selling the product.

Annuities can be used as part of one’s retirement plan.  However, they are not appropriate for everyone.  If you are considering an annuity, you should make sure to understand the different types of annuities, their potential benefits, risks, and fees or costs to purchase a contract.

A Wealth of Knowledge - Winter 2012 Issue

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