Annuities are a great long-term investment strategy. They are ideal for people whose main objectives are long-term financial security, diversification, retirement income, and principal preservation. But what exactly is an annuity? Let’s start from the basics.
What is an Annuity?
An annuity is a financial asset issued by an insurance company that gives you monthly income payments for the period mentioned on the contract regardless of the fluctuations in the market.
You can create a customized annuity based on how long you think you will stay alive, how much you want the monthly payments to be, when you want them to start and whether you wish to leave the income system to your beneficiaries after your death.
How do annuities work?
The concept behind how annuities work is simple. You pay the insurance company a lump-sum premium which is then returned to you in a stream of monthly income. The majority of retired people need more than just social security and investment savings to cover their daily needs.
Annuities are a source of constant income through a process of accumulation and distribution. In the case of immediate annuities, there is no accumulation phase, and payments begin within a month of purchasing the annuity.
On the other hand, when you buy a deferred annuity, you have to pay a premium to the insurance company. The premium grows throughout the accumulation phase and takes up to 30 years based on the agreement and contract.
Once the accumulation phase is over, you will receive regular payments during the distribution phase. Annuity contracts are designed such that the insurance company suffers if there is a downgrade in the market. This means that the annuity owner is safe from the fluctuations in the market and the risk of outliving your money.
In order to tackle this risk, insurance companies usually charge an extra fee for covering contract riders, investment management, and other services.
Apart from this, insurance companies also impose spreads, caps, and participation rates on some annuities, which can reduce the amount of money returned to you.
What is the structure of an annuity contract?
An annuity contract consists of three main parts:
1. The owner
The annuity owner is the one who purchases the annuity, pays the premiums, and can fund annuities, change the beneficiary, surrender the contract, withdraw money or make any changes in the insurance contract. The annuity owner can be an individual person or an entity such as a charity or trust.
2. The annuitant
The annuitant can only be a person and not an entity. The annuitant can be different from the annuity owner, but in both cases, both are the same. The lifetime payments are based on the life expectancy of the annuitant.
3. The Beneficiary
The beneficiary is decided when the contract is signed and is the person who will get the annuity’s proceeds.
What are the different types of annuities?
Annuities are a great way to save money for retirement, but there are many different types of annuities. If you are considering purchasing an annuity, then you should know all the types of annuities available so you can decide which one is ideal for you.
1. Variable annuity
A variable annuity is a tax-deferred investment for your retirement that allows you to invest in bonds, mutual funds, and stocks.
You are part of all the good and bad that comes with a variable and unstable product. Variable annuities are risky as compared to the other types of annuity.
2. Fixed indexed annuity
Fixed indexed annuities earn interest based on how the market performs and its fluctuations. However, fixed indexed annuities guarantee an interest rate that never goes down to zero, even if the market goes down. Such annuities allow you to earn market gains without suffering the downsides and tax deferral.
3. Fixed annuity
A fixed annuity works on a fixed interest rate for the time period of the contract term. It is very similar to a certificate of Deposit. The premium you deposit earns a yearly fixed amount of interest, sometimes called a CD annuity.
There are further two types of fixed annuity; Multi-year Guarantee annuities and traditional fixed, both of which guarantee higher interest returns than CD annuities.
4. Long-term care annuity
It is also a tax-deferred annuity that offers enhanced tax-free benefits in the form of care facilities and services in the long run.
5. Immediate Annuity
An immediate annuity is an insurance contract that has no cash value. The annuity owner gives a lump sum of money to the insurance company and starts receiving immediate payments for the time period mentioned in the contract.
6. Two-tiered annuity
This type of annuity is again tax-deferred in which the annuity owner invests money upfront, the investment grows during the accumulation period and is distributed in the future as a guaranteed income stream.
7. Deferred Income Annuity
A deferred income annuity is a type of income in which an annuity owner submits a lump sum of money today to receive deferred irrevocable retirement payments over the time span of the contract in the future.
8. Secondary market annuity
A Secondary market annuity can be sold in exchange for a lump sum of money.
9. QLAC (Qualified Longevity Annuity Contract)
A qualified longevity annuity contract is also a deferred type of annuity funded by special retirement plans to get the minimum required distributions.
10. Structural settlement
This type of annuity is structured and irrevocable, in which you receive periodic payments from the insurance company that is ordered by the court.
11. Registered Index-linked annuity
This type of annuity is a mixture of the variable annuity and the fixed indexed annuity. When the market index is performing well, the annuity earns interest limited by a participation rate.
On the other hand, if the index falls, the annuity does not earn any interest and loses its value to a floor.
12. The Medicaid annuity
A compliant medical annuity is ideal for those healthy elderly couples in which one of the spouses is unhealthy and receives Medicaid.
13. The charitable gift annuity
This type of annuity can be transferred from the annuity owner to a charity. In return, the annuity owner receives annuity payments. The annuity payments by a donor are tax-free returns based on the actuarial tables of life expectancy.
The bottom line
Now that you know what an annuity is, how it works, and the different types of annuity available, you can decide which one is best for you. Before making the final decision, we recommend that you take professional help.