An annuity offers a way to supplement your income if you already have adequate retirement savings accounts or are simply looking for a way to guarantee monetary distributions over a period of time. Annuities can be useful for supplementing your income on a regular basis outside of a traditional stocks and bonds portfolio. While annuities have some potential drawbacks such as their illiquidity, their benefits are attractive to certain types of investors. There are a few different types of annuities. Today, we will help you understand what they are and how they work.
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What is An Annuity?
Put simply, an annuity is a contract between a customer and an insurance company. In this contract, the customer pays a lump sum of money, then the insurance company agrees to provide disbursements at regular intervals for a specific amount of time. These contracts have tax-free growth and can earn interest depending on the type of annuity. Additionally, there is normally a tax penalty for early withdrawals before a certain age.
Types of Annuities
The five most popular annuities are immediate, deferred, fixed, variable, and indexed annuities. Here’s what you need to know about each:
Probably the oldest type of annuity, an immediate annuity has a simple formula: a customer pays a lump sum of money and receives regular payments for a specific period of time or until their death. Immediate annuities tend to start distributing payments right away or within a year. These payments are usually larger than other kinds of annuities since they include the principal amount along with interest. If a customer is able to forgo their immediate principal, then an immediate annuity may be more beneficial because of its larger income distributions over time.
As the name suggests, deferred annuities invest your initial principal for a specified amount of time before it is withdrawn. As a result, these deferred payments can be greater than those from an immediate annuity because of the interest the annuity accumulates. The period of time before withdrawals are made is called the accumulation period or accumulation phase.
Deferred and immediate annuities can be fixed or variable. A fixed annuity has a guaranteed interest rate, meaning you have a guaranteed and calculable source of income. These tend to be popular with the retired or soon-to-be retired looking for a guaranteed investment. On the flip side, these annuities tend to offer fairly modest interest rates, higher than most savings and CDs but without the opportunity to increase during the life of the annuity.
Again, as the name may suggest, a variable annuity offers an investment with a flexible interest rate based upon the performance of underlying mutual funds. Investors pick from a selection of mutual funds that the annuity is invested in, and growth rate of the annuity is determined by how well the selected portfolio does in the market. Unlike fixed annuities, variable annuities do not offer a guaranteed rate of return but have the potential to provide larger payments if the portfolio does well. Of course, the potentially larger return is matched by the risk that the portfolio does not perform well and the annuity does not grow as much as it could.
Indexed annuities are sometimes treated as a hybrid of fixed and variable annuities. Indexed annuities’ growth rates are tied to a specific index like the S&P 500, so their growth rate is determined by the performance of the index. Unlike a fixed annuity, and indexed annuity has the opportunity for greater or lesser growth, and unlike a variable annuity the buyer does not have control over the selection of the underlying portfolio upon which the growth rate depends. Additionally, indexed annuities can have a participation rate and rate cap that affects their performance.
The participation rate is the percentage of the gain in the underlying index that is reflected in the growth of the annuity. For instance, a 50% participation rate means the annuity would only yield half of the growth in the index it is tied to. A rate cap is a hard limit on the growth of the annuity, typically up to 15%. For instance, if an annuity has a rate cap of 15% and the underlying index experiences an immense 25% gain, the annuity would only gain up to the rate cap and the rest of the index’s growth would not be reflected in the annuity’s performance.
Speak with a Financial Advisor Today
We hope you’ve learned something about the various types of annuities and which may be best for your situation. If you need assistance with your financial plan, the experienced financial planners at The Templeton Group can help you to build a strategy to work toward your goals.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All indices are unmanaged and may not be invested into directly. Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 1⁄2 are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value. Fixed Indexed Annuities (FIA) are not suitable for all investors. FIAs permit investors to participate in only a stated percentage of an increase in an index (participation rate) and may impose a maximum annual account value percentage increase.
FIAs typically do not allow for participation in dividends accumulated on the securities represented by the index. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Withdrawals prior to 59 1⁄2 may result in an IRS penalty, and surrender charges may apply. Guarantees are based on the claims-paying ability of the issuing insurance company.