An annuity is a contract with an insurance company under which you are paid an income stream in monthly payments. The features of annuities can vary in several ways.

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For example, the monthly payments can be a fixed amount (fixed annuity), or be determined by the performance of your annuity’s underlying investments (variable annuity), or can be a combination of both. If the annuity is a variable annuity, you may have options in choosing how your money will be invested.

Annuities may be “deferred” or “immediate.” With deferred annuities, your money is invested and payments begin at a later date, typically retirement age. With immediate annuities, payouts begin immediately. Some deferred annuities may have the option to convert to an immediate one.

The payout options on annuities also are features that can vary. Depending upon the type of annuity, payout options may include:

  • Income for a guaranteed period (which will continue for a named beneficiary if you die before the period is over)
  • Lifetime payments without survivor benefits
  • A combination of the two

For spouses, a joint and survivor annuity can provide for continuation of benefits for the duration of the life of the surviving spouse.

One reason people may choose to invest in annuities is to have a guaranteed income stream at retirement. A fixed annuity can provide a sense of security that, come what may, and no matter what the stock market does, the risk-averse investor will always have that fixed amount of money coming in each month. (However, in the event of inflation, the purchasing power of that monthly payment from a fixed annuity may not be worth what the investor had planned on.)

Many retirees will have other sources of guaranteed income, such as Social Security or a defined benefit pension plan. In terms of function, these income sources are like annuities. Therefore, the investor will need to decide, in light of these other sources, how much of their retirement wealth should be annuitized.

Another reason to choose an annuity is to save extra money for retirement that can grow tax-deferred. Unlike 40l(k)s and other tax-deferred retirement savings devices that have yearly contribution limits, there is no limit to how much money can be invested in an annuity to grow tax-deferred. Thus, if your focus is on getting as much as possible into tax-deferred retirement, and you’ve maxed out 401(k)s, IRAs, etc., annuities should be considered.

A knock against annuities is that they have high expenses and fees. The fees and charges can be complicated and unclear. If you withdraw money from the annuity before the date scheduled for payouts, there can be very steep “surrender” charges. While there are some annuities that are low cost, an investor needs to determine the particular commissions, surrender charges and annual fees that will apply to the specific annuity product the investor contemplates purchasing.

Another criticism of annuities is that many studies show that annuities often are “actuarially unfair,” meaning that the insurance-company payout is less than the discounted present value of the annuity purchase price valued over the expected lifetime of the purchaser.

Money invested in an annuity grows without being taxed, but when it is distributed later, the earnings are taxable as ordinary income. Like 401(k)s and other retirement vehicles, withdrawing money prior to age 59 1/2 can result in penalties.

If you purchase an annuity, make sure it is from a solid insurance company. Although some states have funding to cover insurance claims, at least in part, if the insurance company goes bankrupt, it is very important to buy annuities from insurance companies you are confident will still be in business when you begin drawing payments. You can check the insurance company’s credit rating with services such as Standard & Poor’s or Moody’s.

Annuities have both advantages and disadvantages. As defined benefit pension plans decrease, and if Social Security retirement age gets pushed forward or benefits are cut or do not keep pace with cost of living, more investors may be interested in annuitized alternatives for a retirement income stream. – Mike Wilson, J.D.