Annuities 101: Back to Basics
You may have heard the saying “it’s not your grandfather’s annuity.” That’s because annuity features and benefits have dramatically evolved throughout the past few decades. Yet, the fundamentals of the product remain the same. An annuity is a contract between you and an insurance company. In exchange for the premium paid by you, the insurance company promises to make a series of income payments to you from the annuity, either immediately or at some time in the future. The contract allows for many income payment options, including the frequency of the payments and the length of time in which you receive them. This includes the option to select income payments that are guaranteed to last as long as you live.
Immediate vs. Deferred Annuities
There are several types of annuity products available today, each with its own unique set of benefits. For purposes of simplification however, annuities can be broken down into two main categories: immediate and deferred. The primary difference between the two is when you start receiving payments from the insurer.
Commonly referred to as a SPIA (single premium immediate annuity), an immediate annuity is used to create an immediate stream of periodic income payments. These payments contain a combination of the premium you provided and interest paid by the insurance company, and are fixed in both amount and duration at the time the contract is issued. Payment options include for your lifetime only, for a specified time period only or a combination of both your lifetime and for no less than a specified time period.
A deferred annuity allows for the premium you provide to accumulate interest for a period of time before income payments begin. During the accumulation period, the premium in the annuity earns interest, which grows tax deferred. Additionally, most contracts allow for you to access a percentage of the annuity’s value free of any penalties or charges during this time. Depending upon your contract, you may be able to choose when to start receiving the periodic income payments, or they may begin at the annuity’s maturity date.
The 2 Types of Deferred Annuities
Of the deferred annuities available, the two main types are fixed and variable. The primary difference between them is how money in the annuity earns a return.
Fixed annuities are insurance products that offer guarantees of predictable income you cannot outlive, protection from investment and market risk, and minimum interest earnings in every economic climate. The insurance company calculates and determines the interest to be credited based on the insurance company’s earnings. These earnings grow tax deferred until you begin receiving income payments from the insurer.
A fixed indexed annuity is a type of fixed annuity that earns interest based on the positive performance of a market index. As interest is credited, earnings are locked in to the account value and the account will not participate in any losses. Because you are not directly invested in a market or an index, the value of your annuity won’t decrease as long as you don’t withdraw monies in excess of any penalty-free withdrawal amount stated in the contract.
Variable annuities earn investment returns based on the performance of the investment portfolios, known as “subaccounts,” where you choose to put your money. While variable annuities offer the potential for higher returns, the return isn’t guaranteed. If the value of the subaccounts goes up, you could make money. However, if the value goes down, you could lose money.