Q&A: Annuities

What is an annuity?

Annuities are insurance contracts. Buyers typically contribute a lump sum and pay no taxes on the investment gains or interest until they tap the money years later. The term traces its origin to ancient Rome, where citizens paid a lump sum for a contract that promised an annua, or yearly payment, for life.

What are the different kinds of annuities?

There are two main types: fixed and variable.

Fixed annuities are savings plans that pay interest at a guaranteed rate, adjusted periodically. A retiree who needs income can draw monthly interest and leave the principal intact, or pick from other payout options.

Variable annuities are investments linked to an underlying stock or bond mutual fund. They offer the potential for higher returns than a fixed annuity. But they can also lose money, unless the contracts contain guarantees.

What is an equity-index annuity?

A fixed annuity that pays interest linked to a stock market index, such as the Standard & Poor's 500. Unlike variable annuities, equity-index annuities cannot lose value. They typically offer a minimum guaranteed return, with additional interest based on how the index performs.

How do I invest in an annuity?

With a lump sum or through periodic investments. Most issuers require a minimum initial investment of $1,000 or more, but that may be waived if the investor agrees to make regular contributions. Insurance agents, banks, investment brokers and financial planners sell annuities. They can also be purchased directly from many insurance companies.

Are there fees?

Yes. With variable annuities, they are deducted from the investment. Variable annuities charge 2.3% of assets per year on average, compared with 1.4% for mutual funds, according to Morningstar Inc. The difference reflects the cost of insurance features included in variable annuities, such as death benefits for the investor's heirs.

Fixed annuities carry no stated expenses, but because insurance companies pay commissions to the agents who sell them, they may impose "surrender" charges as high as 25% on withdrawals during the early years. Those charges deter savers from tapping the accounts quickly, allowing the insurance firms to invest the money and earn enough to pay commissions and ultimately pay off the investor while making a profit.

What are the advantages of an annuity?