An annuity is generally issued by an insurance company to an investor under a contract in which the investor agrees to make certain payments to the insurance company and the insurance company agrees to make periodic payments to the investor. A fixed annuity is structured to provide payments back to the investor based on a fixed rate of return on the initial investment, while a variable annuity provides payments based on the performance of the investment vehicles into which the initial funds were invested.
Generally used to guarantee income during retirement, annuities can be structured with varied terms and features. An annuity can be funded with an initial lump sum or periodic payments. Typically, earnings of an annuity are tax-deferred. An annuity may include a minimum guaranteed death benefit payable to a beneficiary in the event of the death of the annuitant.
A fixed annuity usually provides guarantees that the investor will earn a minimum rate of interest during the investment period. The insurance company also guarantees the amount of stipulated periodic payments to the investor. These periodic payments may be for a definite period, such as 20 years, or an indefinite period, such as the annuitant's lifetime or the lifetime of the annuitant and her spouse. The insurance company generally decides the vehicle in which funds under a fixed annuity are invested.
Under a variable annuity, the investor establishing the annuity generally has an option as to what the funds under the annuity will be invested in. The choice is generally from a basket of mutual funds. Because the insurance company does not directly control the investment strategy for these monies, the rate of return and the amount of the periodic payments to be made will vary depending on the performance of the investment option selected. Variable annuities, as bona fide investment products, are regulated by the Securities and Exchange Commission (SEC), while fixed annuities are not.
The rate of return on a fixed annuity will depend on the interest rate climate when the annuity is taken out. An insurance company offering an annuity will attempt to make it attractive as an investment vehicle but will not commit to a return to the investor of much more than the then-current rate for any larger investment product tied to interest rates. Generally, the return will be at about the prime bank lending rate (prime) at the time the contract is signed.
The SEC advises that there is a third type of annuity, an equity-indexed annuity. During the period funds are accumulated under the annuity, the insurance company credits the annuity with a return based on changes in an equity index, such as the S&P 500 Composite Stock Price Index. Typically, the insurance company will guarantee a minimum return. Payout, after the accumulation period, may be periodic or a lump sum, as provided for under terms of the contract. While the typical equity-indexed annuity is not registered with the SEC, it may be because equity-indexed annuities combine features of both traditional insurance products and traditional securities, particularly a return linked to equity markets. Depending on the mix of features, an equity-indexed annuity could be considered a security.