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What Is an Annuity Investment?

I enjoy writing about ways to make money, save money, and use money wisely.

Annuities are nothing new in the investment world. What is new is how popular they have become in recent years due to stock market volatility and turmoil that has made investors look for safe ways to earn high rates of investment returns.

The 2008 stock market crash shook investor confidence to the core. To ride out the economic storm and stock market volatility, many investors simply pulled their money out of the stock market altogether and put their money into low-yielding savings accounts. The newly risk-averse investors soon found the rates of return from low-yielding savings accounts to be inadequate.

Looking for safe investment returns, many investors have recently opted to invest in annuities sold by life insurance companies that offer safer and sometimes guaranteed rates of return. This, in a nutshell, is why annuities are popular investments again. This trend may be accelerating as tens of millions of Baby Boomers near retirement age and seek safer investments for their retirement years that provide decent returns.

Why are annuities popular investments? They are relatively safe investments that avoid stock market volatility and provide decent rates of investment return.

Why are annuities popular investments? They are relatively safe investments that avoid stock market volatility and provide decent rates of investment return.

My Introduction to Annuities

I did not know much about annuities until 2009. In the midst of the worst recession since the Great Depression of the 1930s, my inbox in 2009 was being bombarded by employment opportunities with insurance companies. I found this to be quite odd, given the horrible employment situation at the time. Nobody else seemed to be hiring except for insurance companies that appeared to be desperate to add sales staff.

The reason for this hiring spree by insurance companies was a great uptick in demand for safe guaranteed investment returns by investors who had pulled their money out of the highly volatile stock market that had just suffered one of its worst crashes in history.

During 2009 and in the years immediately following, weary stock market investors began to explore and then invest in annuities to secure a decent return on investment in a relatively safe manner. Investing in annuities suddenly became popular with Main Street America, and insurance companies needed to boost their sales staff to meet the new demand for their annuity products.

What Annuities Are and How They Work

An annuity is defined as a contract or agreement by which one receives fixed payments on an investment for a lifetime or for a specified number of years. By law, annuities are offered only by life insurance companies, and any growth within an annuity account is held tax-deferred until it is withdrawn, at which time it is treated as regular taxable income.

There are two basic types of annuities, fixed annuities, and variable annuities. Fixed annuities offer relatively modest rates of return that are fixed, in a similar fashion as Certificates of Deposit (CDs). Variable annuities offer more robust rates of return that vary depending upon the returns of the underlying assets that comprise the variable annuities, which can include investments in stocks and bonds that are held in subaccounts set up by the insurance company that manages the variable annuity.

Not all variable annuities are the same. Some can lose value if the underlying investments lose value. Others offer a guaranteed minimum rate of return for additional fees that can be realized when the funds are withdrawn as fixed payments upon maturity or when the owner of the annuity passes away, regardless of the performance of the underlying investments.

While annuities offer a safer investment return than investing in the stock market, they can also be quite expensive when all the fees are factored into the returns. Annuity fees are generally a percent higher than stock market index fund fees and more than and a half percent higher than managed mutual fund fees. This may not sound like a lot, but when compounded over many years, these additional fees can make a big difference in the amount of money earned over a long period of time and available at the time of retirement.

What annuities offer that index and mutual funds do not offer is safety. Investors that cannot stomach stock market turmoil, such as the turmoil that occurred during the severe stock market bear market in late 2008 and early 2009, can sleep easier holding annuities that offer a guaranteed rate of return. While savings accounts offer similar guaranteed rates of return, the current savings account interest rates of less than 1% are often considered inadequate by investors eager to see their money grow over time for their retirement.

The reason why annuities are popular investments is because unlike investing money in the stock market and riding out the volatility until the money is needed, annuities can be brought that guarantee an investor will receive a specified minimum level of return and payments in the future when needed, which is known in the annuity industry as a “living benefit.” The three types of living benefit annuities include:

  • Guaranteed Minimum Income: For people who want to contribute money to an annuity and then receive payments in the future as an income stream that is paid periodically for a set period of time or for the rest of one’s life.
  • Guaranteed Minimum Withdrawal: For people who wish to withdraw a set amount from an annuity annually for a specified number of years. If the annuity investments have performed well and the annuity account still has money left in it at the end of the withdrawal period, the owner of the annuity can receive the excess money in a lump sum payment. This type of annuity can also be purchased as a lifetime annuity (for an additional fee), which provides guaranteed payments for life, even beyond the original investment amount.
  • Guaranteed Accumulation: For investors who want to avoid any risk of loss in the stock market but want to capture potential gains from stock market appreciation. This type of annuity guarantees that an investor will recoup at least as much as is invested in the annuity after a period of time, even if the underlying investments that the annuity is based upon do not perform well. This type of annuity can also be purchased as an investment guaranteed to gain a specified percentage per year (for an additional fee), thus locking in investment returns. If the underlying annuity investments outperform the guaranteed amount, the investor receives the additional amount of account appreciation.

Annuity Risks and Shortcomings

Annuities are attractive because they offer a decent rate of return with very little underlying risk based on the contract between the annuity buyer (the investor) and the life insurance company that sells and manages the annuity. However, there is one risk that investors need to be aware of, and that the possibility that the life insurance company that sells them an annuity could go bankrupt, which could put their annuity investment and returns at risk of total loss.

To counter this risk, all states in the United States require life insurance companies that sell annuities to provide annuity insurance coverage of at least $100,000 (some states require up to $500,000) for the buyers of their annuities, which covers the buyer up to the covered amount in the event that an insurance company bankruptcy occurs and payment of annuity obligations is not possible.

Annuities are not suitable investment vehicles for everyone. The higher fees charged by annuity salespersons and managers can make annuities unreasonably expensive and not worthy of investment when compared to other guaranteed investment choices, such as Certificates of Deposit. Also, early termination fees, known as surrender fees in the annuity industry, can be as much as 10%, which is quite steep compared to other investment options.

Annuities should not be used as short-term investments, since the additional fees associated with annuities do not make them suitable for short-term investing. Similar or better rates of return, compared to what can be earned from annuities, are possible over a long period of time in the stock market. However, for those who do not want to worry about their investments and have time to recoup the upfront fees, annuities can be an attractive investment choice, which is why annuities are popular investments again.

Why Invest in Annuities?

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2011 John Coviello


Svaciada from Prague on May 06, 2011:

Wow, cool information, I really like this.

Thank you

chamilj from Sri Lanka on May 05, 2011:

I never knew about Annuities before. Thanks for the detailed information.