What is an Annuity?

An annuity is a series of fixed payments made at regular intervals. This payment stream is the result of an agreement under which the recipient originally paid a sum to a financial institution (such as an insurer), with the institution pledging to return the funds at a later date, plus interest. The payment phase during which the investment fund is built up is called the accumulation phase, while the payment phase during which annuity payments are made is called the annuitization phase. Annuity contracts are commonly used by retirees, who want a long-term income stream and deferred taxable income.

Types of Annuities

There are four main types of annuities, which are as follows:

A fixed annuity has a fixed stream of annuity payments. This is a low-risk option, but may not generate much of a return.
A variable annuity is a stream of payments in which the payments vary based on the success of the underlying investments. This option can generate the highest return, but also presents an increased risk of not generating a return at all.
A deferred annuity provides a guaranteed lump sum or series of payments, which begin at a point in the future. This approach allows your principal to grow before any payouts occur.
An immediate annuity provides an immediate guaranteed lifetime payout. The downside to this option is that you are trading away the initial lump-sum payment for the lifetime annuity.

Problems with Annuities

There are several problems with investing in annuities, which are as follows:

Delayed payback. The risk that annuity holders bear is that the annuities may not begin to pay back for a long period of time, possibly several decades.
Large salesperson commissions. Annuities can involve fairly large salesperson commissions. These commissions are usually taken up-front, so a large part of your initial payments into an annuity are essentially a transfer to the salesperson. This can cut deeply into your return on invested funds.

The net result is that an annuity holder may not experience much of a return on an annuity, despite having made a long series of payments into it. A better option may be to directly invest the funds yourself, rather than entrusting this task to a third party.