Annuities
The basic mechanics
An annuity is a contract that liquidates a lump sum into a stream of income, protecting against the risk of living too long - the mirror image of life insurance, which protects against dying too soon. During the accumulation period the contract builds value; at annuitization the value converts into periodic payments. The payout can be immediate (annuity starting within a year) or deferred.
The key roles are distinct and heavily tested: the owner controls the contract and names the beneficiary; the annuitant's life measures the payout; the beneficiary receives any death benefit.
Types
Fixed annuities guarantee a declared interest rate and a minimum guaranteed rate. Variable annuities invest in subaccounts, shift investment risk to the owner, and are securities requiring a prospectus and securities registration. Indexed annuities credit interest by formula tied to an index, with caps and a floor. Equity-indexed crediting is not the same as owning the index.
Payout options
Straight life pays the highest income but stops at death; life with period certain pays for a minimum number of years even if the annuitant dies sooner; installment refund and joint-and-survivor versions reduce the payment but protect a survivor. The exclusion ratio determines how much of each payment is a tax-free return of the owner's basis and how much is taxable as ordinary income.
Traps and rule of thumb
Surrender charges and market value adjustments hit early withdrawals, and pre-age-59½ withdrawals are generally subject to a 10% federal penalty on the taxable portion. Section 1035 exchanges move annuity or life value between contracts tax-free. Rule of thumb: if a question asks who bears investment risk in a variable annuity, the answer is the owner/annuitant.