Whether you’re aiming to diversify your portfolio or plan your retirement, you’ve probably heard a lot about annuities while investigating your financial options. But what exactly is an annuity? Are there different types? What are the risks and rewards? It’s difficult to make the right decision without the right information. The following provides a foundational understanding of how annuities can play a part in your retirement strategy.
What is an annuity?
An annuity is a contract issued by an insurance company. You pay a premium (either a lump sum or periodic payments) to the insurance company, which invests it to make a profit. The interest is credited to your annuity on top of your original principal. How it is credited, who assumes the risk of the investments (you or the insurance company), and whether there is protection of your original premium from market downturns all depend upon what type of annuity you purchase. When the payout phase of the annuity begins, you can opt to have your money repaid at regular intervals or in one lump-sum payment. Besides the repayment period, annuities come with many different options that depend on your needs and preferences. Many people purchase fixed annuities for the principal protection features, or to manage their retirement income effectively.
Are there different types?
There are many different types of annuities that vary in rate, risk, payout period, and purpose. Since time is an important factor in building your account value, you’ll want to make sure you choose the right one.
Fixed annuities
Fixed annuities guarantee the protection of principal from market downturns, while adding to your account with guaranteed interest rates. Interest rates for fixed annuities are generally slightly higher than those of CDs and the interest is allowed to accumulate tax-deferred. You can choose between deferred or immediate annuities. With immediate annuities, the payouts typically begin 30 days after the premium payment and are fixed amounts sent to you regularly over a certain period of time or for life. Usually, retirees or those close to retirement benefit most from immediate annuities. The deferred annuity defers the start of the payout phase until a later date; the period before the payouts begin is called the accumulation phase of the deferred annuity.
Variable annuities
A less secure alternative to fixed annuities, variable annuities have a higher risk for loss, but also a higher potential for gain. With this type of annuity, you control how your money is invested and you assume the risks associated with the underlying investments. The growth of your account depends on the success of these investments and your principal is at risk. Your personal risk tolerance should be considered when deciding whether a variable annuity is right for you.
Fixed indexed annuities
A fixed indexed annuity combines the fixed annuity’s protection of premium from market downturns with the potential for higher excess interest over the long term. With a guaranteed minimum return — fixed indexed annuities come with noteworthy principal protection. However, your annuity has more opportunities to gain if the stock market rises, as the interest crediting method is partially dependent on the performance of an index, typically the S&P 500. Even though an external market index or indexes can affect your contract values, the contract does not directly participate in any stock or equity investments. You are not buying shares of any stock or index fund.
Pros and Cons
Each type of annuity will have its own set of nuanced advantages and disadvantages. However, the following is a general list of some of the pros and cons of annuities.
Pros
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Annuity accounts accumulate interest on a tax-deferred basis.
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Because the guaranteed components of an annuity are backed solely by the claims paying ability of the insurer, insurance companies are assigned financial strength ratings and are legally required to hold reserves for the total amount of outstanding annuity obligations.
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Annuities can provide income for life, thus offering a stable back up for budgeting retirees.
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With Fixed and Fixed Indexed Annuities, the insurance company takes on most of the risk of the investments.
Cons
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You will be obligated to pay IRS penalties if funds are withdrawn before age 59.5.
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During the first several years of your contract, known as the surrender period, you are limited as to how much of your money you can access. Most contracts allow for 10 percent annual withdrawals without surrender charges during this time.
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With most immediate annuities you are locked in once your payouts begin, so you cannot retrieve your money in the form of a lump sum.
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With variable annuities, although there is the potential for greater gains, you assume the risk of the underlying investments.