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When you buy an annuity, the bank or insurance company invests your money and agrees to pay you back according to the annuity's contract terms. In very basic terms, you make one or more (depending on the contract) payment to the bank/insurer as your investment, and they in turn agree to make a series of income payments to you, starting immediately or at some point in the future, for as long as you live.

Fixed annuities guarantee a set payment amount and are similar to CDs in that they have a fixed interest rate. Check around; often fixed annuities have higher interest rates than CDs.
Note: Always read the contract carefully. Some so-called fixed annuities only fix the interest rate for a specified period, such as one year, and the rate is variable after that.

Advantages

Promises a steady stream of income when you retire.
Guarantees a fixed payment amount and interest rate.
Tax-deferred growth—interest is not taxed until you collect your money.
Typically low investment minimums (as little as $1,000).

Disadvantages

Not insured by the U.S. government or by the insurance company/bank where you buy them.
Often come with high fees and a heavy penalty, called a surrender charge, for cashing before a designated period of time has passed.
Payment amounts do not rise to keep pace with inflation, i.e. they will be worth less as time goes by.

Taxes
Some annuities help you set aside money on a tax-deferred basis. You don't pay taxes on the income (interest) earned by this money until you retire. Other annuities allow you to receive income immediately, but it won't be tax deferred.

How they work
An annuity has two phases: an accumulation phase and a payout phase. During the accumulation phase, you make purchase payments, which you can allocate to a number of investment options. For example, you could designate 40% of your purchase payments to a bond fund, 40% to a U.S. stock fund, and 20% to an international stock fund. In addition, variable annuities often allow you to allocate part of your purchase payments to a fixed account, which unlike a mutual fund, pays a fixed rate of interest. The insurance company may reset this interest rate periodically, but it will usually provide a guaranteed minimum. During the accumulation phase, you can typically transfer your money from one investment option to another without paying tax on your investment income and gains, although you may be charged transfer fees by the insurance company.

At the beginning of the payout phase, you may receive your purchase payments plus investment income and gains (if any) as a lump-sum payment, or you may choose to receive them as a stream of payments at regular intervals. If you choose to receive a stream of payments, you will often be able to choose how long the payments will last, e.g. for 20 years or for your lifetime. In addition, you may be able to choose to receive fixed payments or payments that vary based on the performance of your funds. The amount of each periodic payment will depend, in part, on the time period that you select for receiving payments.
Note: Some annuity contracts are structured as immediate annuities, which means that there is no accumulation phase and you start receiving payments as soon as you purchase the annuity. Annuities with an accumulation phase are called deferred annuities.
Many annuities carry a death benefit: if you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount—typically equal to your total payments. They also sometimes offer optional features (that carry extra charges), such as a guaranteed minimum income benefit, which guarantees a minimum payment amount even if you do not have enough money in your account (perhaps because of investment losses) to support that level of payments.

Fees, Charges, and Penalties
Annuities carry a number of standard fees as well as extra charges and penalties that can be incurred. Like mutual funds, variable annuities often carry some administrative fees (in addition to the administrative fees of the mutual funds it contains!).

A fairly standard charge for variable annuities is the mortality and expense risk charge, which is expressed as a percentage of your account value, typically around 1.25% per year. This charge compensates the insurance company for insurance risks it assumes under the annuity contract and is sometimes applied toward your financial professional's commission for selling the variable annuity to you. (Yes, they get commission; financial professionals get commissions from every investment product they sell you—which is why you need to make sure you understand for yourself the terms of any prospective investment and not just let your planner delegate your money to best suit their pocketbooks.)

Many variable annuities also have penalties for certain actions, such as early withdrawal. For instance, if you withdraw money from your account during the early years of the accumulation phase, you may have to pay a surrender charge, which is usually a percentage of the amount you withdraw (sometimes up to 15%), though many contracts allow for withdrawal of a certain percentage of your account value without incurring surrender charges. Surrender charges, when they do apply, generally decrease over time; for example, a 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on until the surrender period is over. In addition to surrender charges, you may have to pay a 10% federal tax penalty if you withdraw anything before the age of 59½.

Other fees, such as initial sales loads and transfer fees may also apply. Plus, any special features or options you choose for your variable annuity, such as a stepped-up death benefit, long-term care insurance, or the guaranteed minimum income benefit, normally carry additional charges. As with mutual funds, you can find a description of all charges in the prospectus.

Equity-Indexed Annuities (EIA)

The first thing you need to know about EIAs is to be careful with them. Investment advisers get big commissions when they sign people up for an EIA, so some unscrupulous advisers will push EIAs even when they're not the best option for their client. Furthermore, EIAs are not regulated by the National Association of Securities Dealers or the Securities and Exchange Commission (until 2011).

How they work
EIAs are almost always deferred annuities, and during the accumulation period, they credit your account with a return whose rate is based on the performance of a particular stock index. Most EIAs guarantee a minimum return, often 3%, during this period. After the accumulation period, the insurance company will make periodic payments (or one lump sum) to you under the terms of your contract.

It is important to note, however, that even with a guaranteed minimum return, you can lose money with an EIA if your guarantee is based on an amount that is less than the full amount of your purchase payments.

Factors affecting rate of return
The index
Some EIAs use a simple price index, which means they calculate the rate without counting reinvested dividends. This can make quite a difference to your ROR. For example, in the past forty years, the average S&P 500 gain is 3.8 percentage points higher with reinvested dividends than without.

Method of Calculating Index Changes
EIAs also employ different methods for calculating yearly changes in an index, which can produce wide disparities in returns. Three common methods are:

Annual Reset (or Ratchet) - This method credits index-linked interest based on any increase in index value from the beginning to the end of the year.
Point-to-Point - This method credits index-linked interest based on any increase in index value from the beginning to the end of the contract's term.
High Water Mark - This method credits index-linked interest based on any increase in index value from the index level at the beginning of the contract's term to the highest index value at various points during the contract's term, often the anniversaries of the annuity's purchase date.

Caps
Caps are limits on the rate of interest the EIA can earn, regardless of the performance of the index.

Participation rates
The participation rate determines how much of the index's gain will be used to compute the index-linked interest rate. If it is less than 100%, you won't be getting the full index gain. For example, if the participation rate is 80% and the index increases 9%, the return credited to your annuity would be 7.2% (9% × 80% = 7.2%).

Between participation rates and caps, an EIA's earnings can be significantly lower than you might expect. Participation rates and caps may be changed annually, depending on your contract.

Principal Guarantee
Many EIAs provide that you'll receive at least 100% of your invested funds; others guarantee only 90%.

Taxes
Your EIA earnings are tax-deferred until you withdraw them, at which time they are taxed as income; gains from an S&P 500 index fund are taxed at lower capital gains rates.

Fees, Charges, and Penalties
Spread / Margin / Asset Fee
Some EIAs annually subtract a certain percentage of the index gain and call it a "margin," "spread," or "administrative fee." In the case of an annuity with a "spread" of 3%, assuming no cap and a participation rate of 100%, if the index gained 9%, the return credited to the annuity would be 6% (9% - 3% = 6%).

Surrender charges and tax penalties
You also may have to pay a significant surrender charge and/or tax penalties if you cancel early. In addition, in some cases insurance companies may not credit you with index-linked interest if you do not hold your contract to maturity. Also, if you make any withdrawals before the age of 59 1/2, you'll be charged a 10% tax penalty in addition to the income tax on the amount withdrawn.

The final word: Be very careful with EIAs. Read the contract meticulously, and do not rely solely on the assurances of the adviser or salesperson.

Variable Annuities
A variable annuity is part insurance/part security investment; the "variable" means that its value and your income from it is variable—it can move up and down, i.e. you can lose money. Since variable annuities are long-term investments that can tie up your money for many years, the younger you are, the better.

Taxes
Like 401(k)s and traditional IRAs, variable annuities are tax-deferred, which means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within a variable annuity without paying tax at the time of the transfer. When you take your money out of a variable annuity, however, you will be taxed on the earnings at ordinary income tax rates rather than lower capital gains rates. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals.

Choosing an annuity
Like with any investment, before buying an annuity you should request and read the prospectus and compare the costs and earning potential to other variable annuities and to other types of investments, such as mutual funds. You'll also want to consider the financial strength of the insurance company, which can affect their ability to pay any benefits that are greater than the value of your account in mutual fund investment options, such as a death benefit, guaranteed minimum income benefit, or amounts you have allocated to a fixed account investment option.

For more information and helpful examples, see the SEC's page on variable annuities.

See also:
Stocks: What To Look For, How to Trade For Long-Term Gains

Bonds: The Basics

Funds: Mutual Funds, ETFs, Closed-end Funds, Hedge Funds , Oh My!

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