At its most basic definition, an annuity is an investment sold by insurance companies. Like every investments, annuities are a vehicle in which you put money in and hope to get more money out. There are several different types of annuities but each one has two basic components: payouts and returns.
Payouts are either immediate or deferred. Immediate payouts means you begin paying for the investment immediately, deferred means your payments are delayed until a later date. Returns are either fixed (guaranteed) or variable. A fixed return offers a guaranteed return where a variable return offers results that vary with the performance of the funds. Variable returns carry an opportunity for more profit, but transfer a much greater risk. Fixed returns will be less-profitable, but have a lower risk.
When you purchase a fixed annuity, you’ll give a certain amount of money to the insurance company. In exchange, the insurance company promised to pay you a fixed monthly amount for a certain period of time. For example, you can purchase an annuity today, and opt to wait until you retire to receive payments. This type of investment can provide you a monthly income when you decide to retire without using social security or your personal savings.
These types of investments are appealing to some people because it’s a way to take a lump sum of money and stretch it out into an income stream that can support you over time. However, fixed-annuity payments never change or account for inflation. So what might be a satisfactory monthly income today, but might pennies in ten years.
When you begin taking monthly payments from your annuity, you will receive a combination of principal and interest that has been earned in the annuity over time. When you begin payments, you can choose a fixed period, for example 10 years, meaning that payments will be made for 10 years to you (or your heirs). Or, you can annuitize, meaning you’ll get payments until death, but anything “left over” is lost to the insurance company and does not go to your heirs or estate.
A fixed annuity is often described as a reverse life insurance policy. Where a life insurance protects against premature death, the annuity protects against longevity if you outlive your money.
The main difference between a fixed and variable annuity is the opportunity for your investment to grow tax-deferred, as in an IRA and when you retire, you can choose to have the annuity pay you an income, much like the fixed annuity. However, in a variable annuity, that income might be much higher based on how well the underlying investment performed over the years.
A variable annuity is especially attractive to an older person who is making a lot of money and is trying to save aggressively for retirement whereas a slower-growing IRA or 401(k) plan is more reasonable for young people.
If you have questions about the options and/or whether an annuity is right for you, talk with your insurance agent. They can help you make a knowledgeable decision about whether or not investing in an annuity is the best choice for your situation.