What is an Annuity? How Do Annuities Work?
Most people have heard of an Annuity but do not have a strong grasp of the product. Here we answer the questions in easy to read language What is an Annuity and How do Annuities work?
An Annuity is a contract between you and the issuer where you agree to give the issuer a premium principal payment, and in return the issuer guarantees you fixed or increasing payments for the remainder of your lifetime. The issuer guarantees that you cannot outlive your Annuity income payment stream! You will receive an income stream payment provided by your Annuity, every month, every year, for the remainder of your life. The income stream payment is guaranteed and no outside influence will ever stop you from receiving your income payment. Annuities are only issued by insurance companies.
An Annuity can be compared to a savings account at a bank. However, your Annuity is with an insurance company, not a bank. When compared to the interest rate earned in a bank savings account, the interest rate earned in an annuity is typically significantly higher in its growth potential.
An Annuity can be used as a retirement plan that you can fund in a lump sum or smaller payments over time. Annuity deposits grow and compound tax-deferred until you begin making withdrawals. However, unlike typical retirement plans, unless it is an IRA, there is no limit to how much money you can invest in most Annuities.
Types of Annuities
There are a number of different types of Annuities offered by insurance companies. However, most fall into these primary categories:
Traditional Fixed Annuities
A Traditional Fixed Annuity pays a fixed rate of return that is guaranteed by the insurance company. The interest rate paid on Fixed Annuities may or may not outperform the returns of a Variable Annuity, however, they are guaranteed to grow and to never lose money.
Learn more about Fixed Annuities
Variable Annuities
A Variable Annuity (VA) allows the owner to invest in a portfolio of stocks, similar to a mutual fund. Variable Annuities can produce high rates of returns in years the stock market does well, but they are also subject to stock market losses.
Learn more about Fixed and Variable Annuities.
Fixed Index Annuity (FIA)
A Fixed Index Annuity (FIA), also referred to as an Equity Index Annuity (EIA) or Hybrid Annuity, enables the owner to enjoy interest growth tied to stock market performance without incurring any loss of principal because of stock market downturns. Another way of looking at a Fixed Index Annuity is that it is like a savings account with an insurance company that combines the elements of safety found in a bank account with the earnings potential of stock market securities. It is important to note, FIAs do not expose you to any risk or loss of principal or previous interest earned. YOU CANNOT LOSE YOUR MONEY.
Learn more about Fixed Index Annuities.
Single Premium Immediate Annuity (SPIA)
With a Single Premium Immediate Annuity or SPIA, you begin to receive income payments immediately upon purchase. The payments can be structured to last your lifetime, or for a specific period of years. It can also cover the lifetimes of BOTH spouses.
Multi-Year Guaranteed Annuity (MYGA)
MYGAs are very similar to bank CDs. They will pay you a guaranteed fixed percentage based on a specific time period of 3, 5, 7, or 10 years.
Payout Types
In an Immediate Annuity, you begin to receive payments immediately upon investing. This is for people who need immediate income from their Annuity.
In a Deferred Annuity, you receive payments starting at a later date, usually at retirement but can be as soon as 30 days.
Learn more about immediate and deferred annuities.
Liquidity
Most Annuities allow you to withdraw either your interest earnings or during the surrender period up to 10% per year without a penalty (Any withdrawal from an Annuity may be subject to taxes and a 10% federal penalty if taken prior to 59 1/2 years of age).
Most Annuities have a penalty for taking an early withdrawal above the free withdrawal amount, this is called a surrender charge. Typically this surrender charge decreases over a five to ten year period. Some Annuities with surrender charges reward the investor by offering a premium bonus. The insurance company adds on an average of 5% to 10% of your principal to the amount of your opening balance. Premium bonus annuities typically have slightly longer surrender periods, and some charge a slightly higher fee than they charge for their standard Annuity.
For investors who need spur-of-the-moment access to their money, there are also Annuities available that do not have surrender charges. These Annuities do not offer premium bonuses but do provide 100% access to your money at any time without any fees, costs, or penalties.
Read our Guide to Fixed Annuities to learn more about the guaranteed lifetime payment options of Fixed Annuities.
