What is an Annuity?

An annuity is a contract that can increase in value and provide a steady income over a long period of time. People often use annuities to build retirement savings. Annuities can also help you save for a child’s education, create a trust fund, or provide for your spouse or children after you die.

Annuities aren’t right for everyone. They typically take years to become profitable, so they’re usually not a good tool for short-term investments. Talk to an accountant, attorney, or trusted financial adviser before buying an annuity.

An Introduction to Annuities

Insurance companies and agents sell annuities. Banks or investment firms backed by insurance companies may also sell annuities.

When you buy an annuity, you’ll begin paying premium payments. The insurance company or the bank or investment firm issuing the annuity pays a minimum guaranteed interest on your premium payments. The annuity might also give you additional interest or a bonus over the minimum guaranteed interest rate.

Types of Annuities

There are three types of annuities:

  • fixed
  • variable
  • equity indexed

Each type of annuity earns interest differently and has a different level of financial risk.

  • Fixed Annuities

Fixed annuities are the least risky because they are invested in conservative, non-stock market investments, such as government and corporate bonds. You usually don’t have input into how the money is managed.

Fixed annuities generate earnings at an interest rate that the insurance company sets each year. The rate can change, but will never fall below the guaranteed minimum rate.The guaranteed rate might be lower than the interest rate you would earn in a bank savings account.

Many fixed annuities guarantee a rate that is higher than the minimum rate for a number of years but then lowers it later on. Ask your agent for an annuity’s rate history to know what kind of rate you can expect over time.

Market value adjusted annuities are a type of fixed annuity that pays more than the guaranteed minimum rate for a period of time. You may withdraw money before the period ends, but you’ll have to pay an early surrender charge, and the annuity’s surrender value will be based on current market interest rates.

A fixed annuity will probably earn more than the current interest rate, but the insurance company keeps the profit. Insurance companies have an incentive to keep the current interest rate high because high-interest rates attract new buyers.

  • Variable Annuities

Variable annuities can provide greater returns than fixed annuities, but they also have greater risk and require you to him more involved, These annuities are dependent on the stock market and generally don’t make guarantees about earnings. If the annuity performs poorly, you could lose some or all of your original investment.

A variable annuity typically invests in a range of financial instruments, such as government securities, equity indexes, money market funds, and mutual funds of stocks and bonds. Unlike fixed annuities, variable annuities typically allow you to decide how the accumulated value is allocated among the selected investments. Your agent or broker can also decide for you.

For example, you could choose to put 40 percent of your accumulated value into the annuity’s bond fund, 40 percent into its mutual fund, and 20 percent into its money market account. Meanwhile. other people could allocate their accumulated value differently. This means that people who buy the same variable annuity will have different rates of return, depending on the performance of the investments they choose. Most variable annuities will allow you to change your allocation for free a certain number of times per year. The company will charge you for any changes beyond those. Some variable annuities offer a fixed interest account within their investment options. The account essentially acts like a fixed annuity within the variable annuity and guarantees a minimum rate of return. A fixed interest account can be a valuable feature during an economic downturn.

Unlike fixed annuities. variable annuities are classified as securities by the SEC because performance is heavily dependent on the stock market. An agent selling variable annuities must maintain a Financial Industry Regulatory Authority license and a Texas insurance license.

  • Equity-indexed Annuities

Equity-indexed annuities (EIAs) combine features of both fixed and variable annuities. They are riskier but offer higher potential returns than fixed annuities. They are usually less risky and offer lower returns than variable annuities.

EIAs base returns on changes in stock, bond, and money markets, but also have a guaranteed minimum interest rate. The value of your annuity won’t drop below the guaranteed minimum. Some EIAs place a cap on the maximum rate of interest the annuity can earn.

Two features that have the greatest .effect on the amount of interest credited to an EIA are the indexing method and the participation rate.