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What Is an Annuity?

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Last editedOct 20212 min read

How are you planning for retirement? There are numerous contribution plans to choose from when it comes to setting aside a future nest egg, from IRAs to 401(k)s. Annuities offer an alternative to the usual savings accounts, but what is an annuity and how does this type of contract work? We’ll go over the basics below to help you make a more informed investment plan.

Understanding annuities

Annuities are distribution contracts sold by licensed life insurance agents. The annuity holder makes contributions to their account, with these funds then invested by the life insurance company to yield a fixed income stream. That maturity date is called annuitization, after which point the account manager issues the funds either in a single lump sum or in regular payments over time.

There are several annuity formulas used to calculate payment timing. In the case of an immediate annuity, there is no delay in the payments. Deferred annuities are more common, with planned future payments.

A deferred annuity account offers a way for individuals to set aside funds for retirement or other future financial needs, knowing that they’ll receive a fixed income at some point in the future. It serves as insurance to offset the danger of outliving your savings account.

How do annuities work?

Annuities offer several benefits to account holders, but how do they work? This type of contract is primarily designed to provide a steady paycheck equivalent to complement savings accounts. Annuities can also be used by those who have received a large lump sum of money and want to convert it into a steady stream of cash flow.

In the United States, all annuity products are regulated by the Financial Industry Regulatory Authority (FINRA) as well as the Securities and Exchange Commission (SEC). These contracts can only be sold by licensed agents or brokers, who earn a commission on the annuity’s value.

When you open an account, you’ll either pay a lump sum into it or a series of premium payments. This is known as the accumulation phase. Once the issuer starts making payments to the account holder, the annuity is in its annuitization phase.

In between the accumulation and annuitization phases is the surrender period, during which time the investor can’t access annuity funds without paying a hefty withdrawal fee.

Types of annuities

There are three main types of annuities to be aware of.

  1. Fixed: With a fixed annuity formula, interest rates and account value are both guaranteed. The account holder’s premiums are invested in the issuer’s general portfolio and payments are set at a fixed value regardless of investment performance.

  2. Variable: You have more choice when it comes to investment options with variable annuities, with the policy reflecting the fund’s performance.

  3. Indexed: Indexed annuities invest premiums into index funds, which track the performance of financial indexes like the Russell 1000 and S&P 500. As with variable accounts, the annuity’s value could go up or down depending on the index performance.

What is an annuity rider?

As you compare different annuity calculators to look at potential payout, you should also look at their riders. These offer a full menu of added benefits, which do come at added cost. Examples of annuity riders include:

  • Guaranteed minimum income benefit (GMIB): This promises a minimum income for the account holder, which is determined by the GMIB rather than the account value.

  • Guaranteed lifetime withdrawal benefit (GLWB): This rider also promises a minimum amount of lifetime income, but it adds in the account value as well. If you withdraw money over the limit, you’ll reduce your guaranteed income.

  • Added death benefits: Normally, the account value determines the standard death benefit in a life insurance policy. However, you can look for a rider that adds investment performance or other enhancements.

Is an annuity right for you?

Whether immediate or deferred, purchasing an annuity product helps lock in a lifetime income stream. Deferred annuities are better for those between 40 and 65, who already have liquid investments to cover emergencies. It’s best to shop around using an annuity calculator to compare the different rates, timings, and riders available.

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