An annuity is a contractual agreement with a financial institution or an insurance company which is meant to provide guaranteed minimum returns on your investment.
The concept is simple and meant to provide security to an individual who is seeking security for their retirement years. Annuities have been around since the days of the Roman Empire, proving their longevity as a sound and smart investment which allows the investor to grow the investment while also generating income distribution for life (or a period of time of the annuitant’s choice). This effectively supplements one’s paycheck after their retirement.
Annuities can be confusing to some for the simple reason that there are so many of them. They are not all created equally, with different types being better suited for different types of people in a variety of different situations. There are also a multitude of different types of (or lack thereof) investments which an annuity can be tied into.
The challenge is to seek out the product which best fits the investor’s specific set of circumstances.
Types of Annuities
- Immediate Income Annuities
- Deferred Income Annuities
- Fixed Annuities
- Fixed-Indexed Annuities
- Indexed Annuities
- Variable Annuities
The first thing you need to choose when purchasing an annuity is whether you want your income payments to begin instantly or if you prefer to wait a period of time and allow your investment to gain in value prior to beginning income payments.
Immediate Income Annuities:
The immediate income annuity is an annuity which upon purchasing instantly begins generating guaranteed income for the annuitant. This type of annuity is most suitable to people who purchase their annuity at the time of retirement and need to supplement their paycheck with guaranteed payments right away. The immediate annuity is terminated upon death of the annuitant which also makes it ideal for retirees who don’t want to outlive their savings. The major drawback with this product is that it cannot be reversed so in the event of an emergency, the annuitant cannot access the full amount of money.
Deferred Income Annuities:
The deferred annuity is the opposite of the immediate annuity in that it delays income payments until the investor elects to receive the funds. This annuity is broken into two main periods: the period where the annuity generates a rate of return and increases the principal and the period where the annuitant begins to receive payments.
The deferred annuity is most ideal for those who are approaching retirement but still have a few years where they plan to continue to work and don’t need their payments to begin until then.
Once the purchaser chooses between immediate and deferred, the annuitant can then choose between a few variations of how their annuity is invested.
A fixed annuity is the simplest and most stable of all the different types of annuities. In exchange for the lump sum payment by the annuitant, the annuity provider provides a guaranteed fixed rate of return. The fixed annuity will usually not be tied into the stock market, which is part of the reason for its stability. For those looking for a guaranteed rate of return, with no possible fluctuations on the rate or any risk to the initial principal investment, then the fixed annuity is the right product for you. For those looking for a little more potential for returns, even if there is a potential risk, continue to read on.
The indexed annuity (also known as the fixed-indexed annuity) is a newer class of annuity which generates returns on the principal investment from a specified equity-based index such as the S&P 500.
This class of annuities is often advertised as being the best of both worlds in that they have the potential to generate a higher rate of return than a fixed annuity - if the index performs well - while avoiding the pitfalls of the variable annuity in that there is still a guaranteed rate of return even if the index performs poorly.
It is important to note that there is often a cap on earnings potential with the indexed annuity, so if the index performs exceedingly well, the investor will not see the equivalent return as if they had invested in the index directly. This is also the reason that the guaranteed rate of return is able to be offered.
The variable annuity is a product which allows the annuitant to invest their principal investment in multiple professionally managed investments such as stocks, bonds and/or money market funds. The variable annuity is a diverse product which can vary wildly from company-to-company and from year-to-year. The potential for higher rates of return is prevalent with this type of annuity (which also means higher monthly income). However, there is also a higher probability of increased fees for the management of the sub-accounts (investments) and perhaps more importantly, a higher risk of loss of principal investment. While the market historically is always on the rise, the wrong timing with a variable annuity could coincide with a market downturn and cripple the principal investment. Of course by the same token, the right timing can bring a fruitful return and change a good retirement into a great one.