An annuity is a financial contract sold by insurance companies to individuals, guaranteeing a series of regular payments to the buyer. These payments can be structured continue for the individual’s lifetime or for a specified period, usually commencing after retirement. The concept of annuities dates back to ancient Rome, where citizens could purchase annual contracts from the emperor, who would then provide annual payments for the rest of their lives.
In the 17th century, European governments reintroduced annuities, selling lump sum contracts to investors to fund costly wars, with the investors receiving predetermined payments in return.
In the United States, annuities initially supported church ministries. The first annuity contract available to the general American public was introduced in 1912 by a life insurance company based in Pennsylvania. Throughout the 1950s, these contracts continued to evolve and expand, eventually becoming widespread by the 1980s.
Annuities offer certain tax benefits to their owners. Holders of annuities are only required to pay taxes on their contributions when they begin to withdraw funds or receive distributions. All annuity contracts are tax-deferred, meaning that the investment earnings within the annuity account continue to grow without being taxed until the owner withdraws them. However, annuity earnings withdrawals before age 59½ may incur penalties.
There are two main types of annuities: fixed annuities, which guarantee a set payment amount, and variable annuities, which do not guarantee payments but offer potential for higher returns. Despite being considered safe, annuities typically provide low returns.
Annuities were developed to protect the owner against the risk of outliving their retirement income, a risk known as superannuation. The fundamental idea behind annuities is to mitigate the risk of exhausting one’s retirement funds. Conservative investors often favor annuities because they continue to provide payments until the holder’s death, even if the total payments exceed the amount remaining in the annuity.
Annuities are consistently classified as retirement savings vehicles and consist of two distinct phases: the accumulation period and the distribution period. During the accumulation phase, owners can choose to make either a large lump sum payment into the annuity or regular payments over time. If the owner passes away during this accumulation period, their heirs receive the amount of money that the owner paid into the annuity contract, subject to estate taxes and regular income taxes.
When the owner reaches retirement age, the process of annuitization begins, marking the start of the distribution period. At this point, the accumulated funds are converted into annuity units. Essentially, the owner exchanges the lump sum amount in the contract for a guaranteed series of payments. Once this conversion occurs, the lump sum is no longer accessible. Instead, the guaranteed income for life commences during this distribution phase.
The distribution phase offers various payment options, including Straight Life contracts, which pay based on life expectancy and cease upon death; Life with Period Certain, which ensures payments for a minimum period or until death; Joint Life, which pays until both owners are deceased; and Joint Life with Period Certain, which guarantees payments for a minimum time period until both owners have passed away.
