Annuities have become popular financial products, particularly for people who are retired or nearing retirement. If you are unsure of exactly what an annuity is, you are not alone. They can be confusing.
Understanding that there is so much confusion surrounding annuities, we are going to take a quick look at the major types of annuities.
The first thing to understand is that an annuity is a contract that you make with an insurance company that is designed to help you meet long-term goals such as funding your retirement.
There are two parts to an annuity contract, the accumulation phase, where you pay into the annuity account, and the payout phase, where the insurance company makes payments to you. The accumulation phase can consist of you writing one check, or you can make payments of a period of time. During the distribution phase, the stream of payments coming to you consists of the money you initially paid in, plus interest or investment gains.
There are several different types of annuities. The three major types of annuities are fixed, indexed and variable.
In a fixed annuity, the insurance company agrees to a specified dollar amount for the payments are made into your account, based on a specific rate of interest while your account is growing. They can vary in the length of time that payments are made. For example you can set up a fixed annuity that will pay you a specific amount of money each month for 20 years, or one that is set up for a non-specific time period, such as for your lifetime starting at a specific age.
With an indexed annuity, your account growth is tied to a specific market index. For example you can tie your indexed annuity to the S&P 500, so that any money invested will earn the same return as the S&P 500 while it is growing. Just in case the markets really run into trouble, the contracts typically state a minimum amount for the contract value regardless of how poorly the index performs.
In a variable annuity, you get some choices about how the money gets invested. Typically, these choices consist of a range of mutual funds. In a variable annuity, the amount of money you can expect in future payments is tied to the performance of the investment options you choose.
As you can see, of the three types of annuities, variable annuities are the most risky. With a fixed annuity, you know for sure what your payouts will be, which limits you upside, but also limits the downside. With an indexed annuity, there is some additional risk, but it is also possible to realize some bigger investment gains than with a fixed annuity. The variable annuity carries the most risk, but also has the most potential for investment gains.