Should You Consider An Annuity?

Annuities have long been a sleepy form of investment favored by only the risk-averse. But lately, two overlapping events have brought this financial instrument back into the spotlight.

The first event was the stock market collapse of late 2008 and 2009. True, those who rode it out have recovered nicely, but plenty of people panicked and took big losses. Feeling burned, their risk tolerance has gone down a notch or two.

The second coinciding event is the aging of the Baby Boom generation. The first Boomers are retiring this year and are in search of stable income. Some are looking at their retirement accounts, which are currently in stocks and bonds, and wondering if they shouldn't convert them to an annuity.

What is an annuity?

An annuity is a contract between you and an insurance company, under which you make a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments to you beginning immediately or at some future date.

In other words, it is guaranteed income, sometimes for the rest of your life.

Annuities typically offer tax-deferred growth of earnings and may include a death benefit that will pay your beneficiary a guaranteed minimum amount, such as your total purchase payments.

According to the U.S. Securities and Exchange Commission (SEC), there are generally two types of annuities -- fixed and variable.

Two types

In a fixed annuity, the insurance company guarantees that you will earn a minimum rate of interest during the time that your account is growing. The insurance company also guarantees that the periodic payments will be a guaranteed amount per dollar in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.

In a variable annuity, by contrast, you can choose to invest your purchase payments from among a range of different investment options, typically mutual funds. The rate of return on your purchase payments, and the amount of the periodic payments you will eventually receive, will vary depending on the performance of the investment options you have selected.

An equity-indexed annuity is a special type of annuity. During the accumulation period - when you make either a lump sum payment or a series of payments - the insurance company credits you with a return that is based on changes in an equity index, such as the S&P 500 Composite Stock Price Index.

Guaranteed minimum return

The insurance company typically guarantees a minimum return. Guaranteed minimum return rates vary, however, and because they involve a guarantee, they are very likely to be below prevailing market rates. After all, the insurance company is assuming the risk you don't want to take.

After the accumulation period, the insurance company will make periodic payments to you under the terms of your contract, unless you choose to receive your contract value in a lump sum.

Variable annuities are securities regulated by the SEC. Fixed annuities are not securities and are not regulated by the SEC.

Equity-indexed annuities combine features of traditional insurance products (guaranteed minimum return) and traditional securities (return linked to equity markets). Depending on the mix of features, an equity-indexed annuity may or may not be a security. The typical equity-indexed annuity is not registered with the SEC.

Rate of return

The knock against annuities has been their miserly rate of return and somewhat hefty fees. As demand and interest has grown in the last two years, however, some insurance companies have gotten more competitive in that regard.

The length of time you pay into an annuity can be a onetime payment, purchasing an annuity with a large block of cash, to making a number of small payments over your working life.  The amount of money you receive from the annuity will depend on how much money you have put in and your age when you start receiving the payments.

Despite their recent popularity, annuities remain a contentious subject among financial planner. The editors at Smart Money recently observed that popularity is no indicator of practicality.

"The truth is, annuities only make sense for a fraction of the population," the publication says. "The rest of us should be buying plain old mutual funds."

Most people choose annuities because they believe there is no risk. But just because the investor is not assuming risk, that does not mean there is no risk in the investment. In annuities, the insurance companies are assuming the risk and therefore, in most cases reaping the reward.