An annuity is a contract with an insurance company in which you make a lump sum payment or series of payments and in return obtain regular disbursements beginning either immediately or at some point in the future based on the initial payment and other factors.
The goal of annuities is to provide a steady stream of income during retirement. Funds accrue on a tax-deferred basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59.5.
There are two basic types of annuities. Fixed and variable annuities.
A variable annuity is a tax-deferred retirement vehicle that allows you to choose from a selection of investments, and then pays you a level of income in retirement that is determined by the performance of the investments you choose.
The annuity contract is issued by an insurance company and is non-negotiable for individual investors. The interest earned in a variable annuity is derived from the performance of mutual fund-like accounts called sub-accounts.
Variable annuities can go down in value when the general market goes down. They perform very similar to mutual funds. They also have a much higher potential return than the other annuity options. They offer the best hedge against inflation when compared to the other annuities but also carry the most risk.
Fixed Indexed Annuity
A fixed indexed annuity also offers a variable rate of return with one major difference. You cannot lose money in a fixed indexed annuity. Performance is based on a specific index and not invested in the market. They pay guaranteed rates of interest, in many cases higher than bank CDs.
Fixed annuities can be deferred or immediate. The deferred variety accumulate regular rates of interest and the immediate kind make fixed payments – determined by your age and size of your annuity – during retirement.
The convenience and predictability of a set payout makes a fixed annuity a popular option for retirees who want a known income stream to supplement their other retirement income.
If you owned a fixed indexed annuity, you would only see your values go up. However, the increase will not always equal the growth of the index you chose to base your earnings. Indexed annuities also have cap rates and participation rates that effectively limit how much you can earn. Keep in mind that you cannot lose money so your earnings are always positive.
All fixed annuities have unusually high surrender charges. It is especially so if you use a bonus annuity. A fixed indexed annuity that offers a bonus will have a long and high surrender charge. The bonus is like free money except there are rules associated with withdrawing the bonus. The rules are designed so that you do not take your money and run. All annuities are long term investments and should not be used if the surrender charge is anticipated to be a problem.
Fixed Interest or Immediate Annuities
Fixed interest annuities are the simplest form of annuity. They are also called multi-year guaranteed annuities. Although they are not issued by a bank, they work basically the same as CDs. They pay a fixed interest rate for a fixed amount of time. Interest stays in the annuity unless otherwise designated. They also have surrender charges so be sure to leave your money in for the entire term.
Immediate annuities are a little more complicated but not much. An immediate annuity is for immediate income over a certain period of time. You choose the time period that suits your needs best including a lifetime income option. Then, you deposit money. Your money earns interest and is paid back to you, principal and interest, over the set period of time. Be sure to understand that when the income stops, your account balance is zero. Immediate annuities are used often in conjunction with income planning as well as estate planning to fund life insurance policies.