An annuity is an investment product offered by life insurance companies. Most individuals think of an annuity as a financial investment; however, when you buy an annuity, you are actually purchasing an insurance policy. Here, we will answer a very popular question, “what is an annuity?”
You simply put funds into the annuity contract or policy, and then the insurance company offers you a guarantee as to when and just how you will get that money returned, and what interest rate you will earn on your investment. There are numerous types of annuities and all of them contain certain nuances that are available to satisfy your savings and earning goals.
Given that there are so many forms of annuity solutions, it can lead to a lot of confusion regarding what an annuity truly is and how it will work for you. You may have also heard robust arguments for and in opposition to annuities, but the truth of the matter is that it all depends on what kind of annuity you are discussing and what purpose you plan to use it for.
Let’s look under the hood of the five leading types of annuities you are probably going to come across:
- Immediate annuities
- Fixed annuities
- Variable annuities
- Deferred annuities
What is an Annuity and How Does an Immediate Annuity Work?
When you purchase an immediate annuity, you pay the insurance company a one-time payment and then the insurer will pay you a guaranteed monthly income. They will pay your income out over an established period, such as ten years (this is called a term-certain annuity), or they might guarantee your monthly income as long as you live.
You can think of your immediate annuity that pays out for a lifetime as a jar of candy. You pay the insurer your investment (a full jar of candy), and they give you back a piece of candy every single year.
If your candy jar ends up being empty, the insurer guarantees to keep giving you candy anyway for the rest of your life. In return, you agree that once you give them the candy jar, you cannot reach into the jar and take a piece of candy anytime you wish. If you think during the year you want three pieces of candy instead of one, you will need to get them from someplace else — not from that jar.
This never-ending amount of candy means a lifetime payout annuity is an effective hedge against living longer than expected. Regardless of how long you live, and regardless of how much of your other money you shell out early in your retirement, you will still get a piece of candy each year. If you are an older and single retiree, an immediate annuity will help make certain you don’t outlive your money.
How Does a Deferred Annuity Work?
When you select a deferred annuity, you will deposit money today, so that an income stream is guaranteed to start at a specified time in the future, generally about ten years from when you originally purchased the annuity. This kind of annuity could help minimize the risk that a significant downturn in the stock market would forestall your planned retirement date.
Most fixed, indexed, and variable annuities provide a postponement component where you have the choice to buy a guaranteed amount of future income. These characteristics go by names like guaranteed withdrawal benefit, living benefit, guaranteed income riders, etc.
A deferred annuity might also be called “longevity insurance,” and there is a unique type of deferred annuity, known as a Qualified Longevity Annuity Contract (QLAC) that you can buy with your 401(k) or IRA money. Under a QLAC, your income usually begins at age 85, so you purchase this type of annuity to make certain that you will have a minimum amount of income when you’re older.
What is an Annuity and How Does a Fixed Annuity Work?
A fixed annuity is a commitment by an insurance company in which the company offers you a guaranteed amount of interest on your investment. Your fixed annuity is compatible with a Certificate of Deposit (CD) issued by a banking institution. Rather than a bank guaranteeing your interest rate, the insurance company is offering you the guarantee.
Using a fixed annuity, the interest builds up tax-deferred. You only pay taxes whenever you take a withdrawal. Any interest you withdraw before turning 59-1/2 is subject to a 10 percent early-withdrawal penalty, and ordinary income taxes.
Your interest rate is typically guaranteed for a fixed period, such as five or 10 years. After that time has expired, the insurer will notify you how much your new interest rate will be. At that time, you can maintain your annuity, swap it for a different kind of annuity, or (similar to a CD) cash it in and choose to invest the money elsewhere.
Typically, fixed annuities contain surrender charges, therefore if you cash in your annuity contract early, always be prepared to pay a substantial fee. A fixed annuity might be a practical option if you prefer a low-risk investment, may possibly be in a lower tax rate in the future when you take out the funds and are prepared to leave your funds in the contract for the appropriate amount of time.
What is an Indexed Annuity?
An indexed annuity is a form of fixed annuity that is usually known as a fixed indexed annuity (FIA) or an equity-indexed annuity. With this form of annuity, the insurer provides a minimum guaranteed return on your investment combined with the possibility for additional returns by utilizing a strategy that links the increases in your account to the stock market.
Indexed annuities come with complex features such as participation rates and cap rates that spell out the formulas for how your returns are calculated. Compare these types of features side by side when reviewing this type of product. Think of this product as an alternative to a CD, not as an equity alternative. If anyone suggests it to you as an equity alternative, think again.
Many indexed annuities also come with certain features that assure you the amount you can withdraw later on when you are retired. This kind of annuity product is known as a deferred indexed annuity, and it can be an excellent choice for an individual about ten years short of retirement, as it guarantees the income they’ll receive in the future.
What is an Annuity and How Does a Variable Annuity Work?
A variable annuity is an arrangement with an insurance company where you get to decide how the money inside the contract is invested. The insurance company offers a list of funds (called sub-accounts) to pick from. The product is called a variable annuity because the money you earn will fluctuate depending on the underlying investments you select. Compare this with a fixed annuity, where the insurer is providing you with a guaranteed interest rate.
The investments within a variable annuity accumulate tax-deferred, therefore, just as within an IRA account, you can swap between investments without having to pay any capital gains taxes. For a variable annuity to qualify as an insurance contract, certain guarantees must be offered.