What Is an Annuity?

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Wall Street is notorious for creating financial products that are difficult to understand. One such product is the annuity, and even experienced investors often have trouble coming up with an annuity definition that's easy for a beginner to understand. Nevertheless, with many financial planners recommending certain types of annuities to their clients, it's important for you to learn what an annuity is, and whether it's suitable for your situation.

Defining annuitiesThe meaning of the word "annuity" comes from the Latin root for year, emphasizing the essential nature of the product as providing annual income to its owner. Historically, the term referred to annual allowances that people received from various sources, including family members or legacy bequests.

The modern definition of an annuity is broader. As the SEC describes it, an annuity is a contract with an insurance company that requires it to make payments to you, either immediately, or at a specified time in the future. You can buy the annuity either with a single payment or with a series of payments. The insurance company can satisfy its obligations either with a lump-sum payment, or through a number of options that involve a longer payout period.

Annuities come in several different types. Fixed annuities are designed to offer predictable streams of income, providing minimum rates of interest, but little opportunity for growth. Variable annuities, on the other hand, are contracts that are tied to different types of investments, including stock mutual funds and similar investment vehicles. By its nature, you can't be certain what a variable annuity will pay you, as its returns are tied to the investments linked to the particular annuity you choose.

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The pros and cons of annuitiesAnnuities have good points and bad points. On the favorable side, annuities are among the only financial products that can address what has become known as longevity risk, better known as outliving your money. Annuities can be structured to make set payments for your lifetime, with the insurance company taking on the risk of your living longer than your life expectancy in exchange for a potential profit if you die earlier than your life expectancy would predict.

In addition, annuities get favorable treatment under the tax code. In particular, annuities give investors tax deferral, with any rise in the value of the annuity contract not being taxed until the owner starts taking money out of the annuity.

On the other hand, annuities have some unattractive features. Costs can be higher than on other types of investments, with fees going to the insurance company to cover mortality and insurance-expense risks. You might have to pay surrender charges to cash in an annuity before a certain number of years passes, with tax penalties also potentially applying to annuity withdrawals before age 59-1/2. In addition, administrative costs can also boost overall costs.

Moreover, many annuities are structured so that after you die, your heirs receive nothing. That allows you to receive larger payments than you would otherwise be able to generate from an investment portfolio; but many are uncomfortable with the thought of potentially losing every penny of their investment if an unforeseen accident or illness led to their death shortly after buying the annuity.

Finally, annuities offer a number of guarantees and other features that can be well-suited to certain investors' needs. For instance, guarantees of minimum income benefits or minimum withdrawal eligibility can give investors additional protection against market swings, especially for those who choose variable annuities. However, these guarantees also come with an extra cost; so when you add up all the fees associated with an annuity, the amount of money taken out of your annuity account can be sizable, and weigh on your long-term returns substantially.

Should you use annuities?Annuities bring out strong emotional responses from their proponents and their detractors. It's true that features tied to life expectancy are almost impossible to duplicate with any other type of financial product, making annuities especially useful for those who want to eliminate that aspect of risk in their financial planning. Yet critics point to high commissions paid to insurance salespeople as a sign that customers overpay for annuity coverage, and you'll find many stories in which inexperienced investors were sold annuities without fully understanding their features.

If you have a need for the insurance element that annuities can provide in ensuring a lifelong stream of income, then including annuities in your overall investment portfolio can be a smart move. Yet if you don't understand exactly how a particular annuity product works, it's a fair bet that the annuity is more complicated than what you actually need to meet your financial-planning wishes. If you do buy an annuity, it's critical for you to understand the exact terms governing how you'll get paid, and any costs associated with the account.

The article What Is an Annuity? originally appeared on Fool.com.

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