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What Is An Annuity?

What Is An Annuity?

December 20, 2021
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Annuities can be complicated and complex, but understanding them doesn't have to be. Annuities have grown in popularity over the years for many reasons, but they have also become a topic of controversy. Deciding if an annuity is appropriate for you can be a difficult decision, and choosing which annuity is appropriate based on your goals can be even more challenging. Today's topic will cover what annuities are, how they work, the most common types of annuities, and a few things to watch for and ask if you are thinking about purchasing an annuity.

What is an annuity?

An annuity is a contract between an individual and a life insurance company. An individual will purchase an annuity with either installments or a lump sum payment or rollover to a life insurance company in an annuity contract. The life insurance company will then provide a form of growth potential or income potential to the annuitant based on the terms of the contract. This may sound pretty simple, but unfortunately there are many life insurance companies selling annuities. Many companies have their own "bells and whistles" attached called riders which are used to attract prospective buyers. One thing that is important to remember is when you purchase an annuity, you a contract.

How does an annuity work for retirement savings?

There are typically two sides to an annuity contract. The first is the accumulation side, and the second is the income side. The accumulation side will determine how the value of the invested principal can grow during the accumulation phase. We will discuss the most common types of annuity accumulation next, but for now just remember that the accumulation phase is the growth phase for the annuity. The second side is the income side. This second stage is where the annuitant will start taking income from their annuity, often used as an income source in retirement. Something important to remember about the phases of an annuity is that though most life insurance companies will often offer similar options for their annuity products, each annuity will have its own rules and terms. These terms will impact how the annuity can benefit the individual and should be considered before purchasing the annuity.

What are the most common types of annuities?

The common types of annuities are: fixed annuities, fixed-indexed annuities, and variable annuities. These types will affect both the accumulation phase of the annuity, and can also affect the income phase. Below we will discuss the basics of these three annuity types.

Fixed - A fixed annuity provides a fixed rate of return for the growth of the invested funds in an annuity. Though the rate of return is fixed, the fixed rate can fluctuate to some degree. For example, an individual can purchase a fixed annuity paying 1.3% fixed interest per year, and have a guarantee in the contract that the interest rate may never decrease below 1.0% annual return. That means that in a future year the life insurance company could decrease the 1.3% annual ROR (Rate of Return) to as low as 1.0%. This is an important consideration for fixed annuity buyers.

Fixed-indexed - A fixed-indexed annuity is considered a fixed annuity because the annuity has the benefit of providing principal protection for funds invested into the annuity, while providing some upside potential along the way. For example, let's imagine an individual invests $100,000 into a fixed-indexed annuity with a 0.00% floor, and a 4% annual point-to-point cap following the S&P500 index. The annuity has principal protection that the $100,000 principal amount will not decrease if the S&P500 were to perform negatively. This is the same way that if the market were to decrease in a fixed annuity, the principal amount would not be impacted. The difference is how the funds grow. Instead of taking a fixed ROR like in a fixed annuity, the fixed-indexed annuity does not have a guarantee of interest each year. In the fixed-indexed annuity the funds will grow based on the growth of the selected crediting strategy within the contract. In our example, that is a one year term based on the S&P500 with a 4% annual cap rate. That means the maximum earning potential for the investor each year is 4%. This can be a way for an individual to have more upside potential than a fixed annuity, while still maintaining the benefit of safety of principal.

Variable - A variable annuity has one distinctive difference between fixed and fixed-indexed annuities. Variable annuities assume market risk. This is because their investment options are invested into sub-accounts which often invest in securities like mutual funds. This means that variable annuities assume risk to principal, but in contrast also have the benefit of potentially higher ROR than both fixed and fixed-indexed annuities. The amount of risk taken will be determined by the portfolio within the sub-account chosen by the annuity contract owner, but remember, whenever you invest in the market there is always the risk of loss of principal.

No matter the type of annuity you purchase, there will always be pros and cons. The important thing to consider is what type of annuity, and specifically which product is appropriate for you as an individual. Remember that insurance companies spend a lot of money marketing their products, and it can often be difficult determining which option out of the seemingly endless list of options will be appropriate for your individual needs and investment objectives. Speak with your financial professional before purchasing an annuity. If you aren't sure what type of annuity is appropriate for you, or if you are stuck choosing between a few, let us know and we would be happy to help.