Annuities Explained: The Simple Guide

by Rob Phillips, CPA

Annuities are often misunderstood, frequently sold to the wrong people for the wrong reasons, but fundamentally they offer unparalleled guarantees to income, principal, and safety.

Aligning your interests and a reasonable portion of your assets with a strong insurance company with excellent credit ratings and reserves is a smart thing to do.

Conversely, believing the you are smarter than the market, can manage your own investments for optimial performance, and that you can take income out of your portfolio year after year and never face a shortfall or the threat of running out of your money during your lifetime, his hubris.

It is our belief that a portion of an investor’s assets should be allocated to lifetime guaranteed income. Guaranteed income should be sufficient to cover guaranteed expenses.

Guaranteed expenses are guaranteed to increase over time as inflation is a prevalent factor in our economy, so whenever possible, guaranteed income should be inflation adjusted or should increase with time.

If the dummy knows nothing else about annuities other than that they can produce income for life, and that that is a good thing, then that is sufficient.

An annuity is a series of future payment streams. You can receive an annuity from an employer, from a parent, or from a lottery payment, among many other sources.

Traditionally, people think of annuities as investments offered by insurance companies. Technically speaking, this is not correct. An annuity from an insurance company is an insurance product, not an investment.

The exception is a variable annuity, which is a vehicle for making stock market investments wrapped in a series of guarantees in the variable annuity contract. Variable annuities are treated as securities, whereas most other annuities are considered insurance products.

In recent years, the SEC and FINRA have made attempts to regulate fixed index annuities, also known as equity index annuities. These insurance contracts are very similar to fixed annuities, however the appreciation rate is based on the performance of a stock market index.

The principal is not directly invested in the stock market, rather the return to the contract holder is tied to the performance of the underlying index. As such, these are insurance contracts with an insurance company, and not securities investments.

Tax Deferred Annuity

Insurance companies enjoy tax treatment that allows them to grow investments on behalf of their policyholders tax-deferred. You may have seen this in life insurance contracts with a cash value, and the same rules apply to annuities. The premium invested in an annuity can grow tax-deferred and compounding while the annuity contract is in force.

It is important to note that, unlike life insurance which is tax-free, the cash value or account value inside an annuity growing on a tax-deferred basis is not tax-free. Taxes will be due and payable when you surrender an annuity, or when your heirs inherit an account.

There are a variety of other terms associated with annuities that you will find throughout the site. Some of the most common points of confusion are:


Riders to annuity contracts often make provisions to turn and appreciating some of money into an income stream. Companies have different trade names for these riders. These names include Guaranteed Minimum Withdrawal Benefit (GMWB), Guaranteed Lifetime Withdrawal Benefit (GLWB), Guaranteed Lifetime Income, (GLI), among others.

Essentially, each of the writers mentioned above offers benefits that turn and accumulating account value into an income stream. Frequently, annuities with these kinds of riders will have a parallel, Phantom account known as a benefit base, or income account.

Hybrid Annuities

In reality, annuities that offer appreciation and income benefits in one package are a hybrid annuity- a hybrid of tax-deferred appreciation, and income stream. These hybrids meld the fundamental nature of a tax-deferred appreciating and investment vehicle with an immediate income annuity.

It is important to seek out expert advice when considering an annuity with a variety of features and benefits. Contractual provisions can get very confusing, and frequently sales literature is misleading when compared to actual contract provisions.

Surrender Schedules

Another area of frequent confusion with annuity contracts is surrender schedules. Annuities are insurance products that are sold by primarily insurance agents. Annuities are also long-term commitments by an insurance company to the policy owner.

There are significant costs in marketing these contracts and in placing investments in suitable vehicles that will yield long-term stability to both the policyholder and to the insurance company.

consequently, most annuity contracts have some form of a surrender schedule whereby if you cancel the contract early, you will pay either a penalty or forfeit some portion of your appreciation.

Some people see this as unfair, however it only makes sense for the insurance company to recover some of its costs if their long-term plans are disrupted. This is not dissimilar to a real estate loan which has a prepayment penalty, something that is common in commercial loans.


altogether, there are a wide variety of definitions and terms in the annuity marketplace. it is important to understand the terms so that when reading contracts or sales literature, you understand what is being said. if it any time you would like to engage the services of an annuity expert, please do not hesitate to call.

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