An annuity is a contract between an individual and an insurance company. Traditionally, you would make a lump-sum investment or series of payments and, in return, receive regular income payments, beginning either immediately or at a designated time in the future such as in retirement.
There are 3 main types of annuities available on the market which are fixed annuities, variable annuities, fixed-indexed annuities. These three main types can also be offered in the form of immediate annuity ( starting income payments immediately ) or deferred ( starting income in the future.) To be clear although annuities were initially designed to provide income to the annuitant many annuity products today offer an accumulation-only strategy. These are designed to grow your initial investment without the intention of ever receiving a scheduled income but rather cashing out at the end of your term.
Choosing the right one depends on several factors, including your risk orientation, income or accumulation goals, and time horizon. Below is a comparison chart of the types available on the market.
Fixed annuities earn a guaranteed interest usually yearly. This predictability and low risk come with a relatively modest annual return, especially in a low-interest-rate environment. It would be fair to say that you would earn slightly higher rates than a CD from a bank. Indexed annuities offer returns tied to the performance of a market index, such as the S&P 500. In the years where the market index gains you would participate in the gains but when the market index goes down it would be protected from the losses by returning a lower fixed interest or in most cases a zero return depending on the contract. Participation rates vary widely based on the type of index and the annuity contract. Some insurance companies offer indexes with participation rates of 100% while other options offer 25% or lower. Variable annuities are invested in a similar fashion as the stock market. You usually have a menu of allocation options in different mutual funds that go in your personal sub-account. Variable Annuities provide the potential of higher return but also carry much greater risk. Unlike fixed and indexed annuities you can lose a substantial value of your account in periods of market corrections or even if the mutual fund selected is losing value. Fees: Once you have chosen the right type of annuity to fit your needs, you’ll want to check the fees involved. Traditionally annuity contracts came with annual fees sometimes as high as 2-3% of your investment value, whereas nowadays there are many annuity options that have zero annual fees. Other potential fees to be mindful of are early termination fees AKA surrender charges. When you take the funds out of annuity prematurely you may have to pay penalty fees.