Annuities 101: An Introduction To What Annuities Are and How They Work

Annuity Definition: An annuity is a unique product of the life insurance industry that offers clients the opportunity to save and accumulate money on a tax deferred basis for retirement, and then receive a guaranteed income stream during retirement or for the rest of their lifetime.

The key to understanding the basics of annuities, is to understand the different ways in which annuities are typically categorized.

The two most common ways to categorize annuities are by:

  1. Timing – Immediate Vs. Deferred (when will income payments begin)

    In an Immediate Annuity, a person gives a lump sum of money to an insurance company in exchange for a stream of income payments that begin immediately.

    In a Deferred Annuity, a person will typically fund the annuity over time, usually by making contributions or deposits throughout their working career.  The income payments do not begin until a future date, usually at the start of their retirement

  2. Interest Rate – Fixed Vs. Variable (how interest growth is credited)

    A Fixed Annuity refers to the fact that the rate of return that a person earns within the contract is either guaranteed by the insurance company, or is earned and credited on a consistent, predictable basis throughout the life of the contract.

    A Variable Annuity refers an annuity that invests in mutual funds or other securities and equities within the account.  While Variable annuities can be an attractive option to some investors, it is important to understand that Variable Annuities typically come with greater investment risk and certain additional fees than most Fixed Annuities, due primarily to the non-guaranteed nature of the underlying securities within the annuity account.  Generally speaking, interest credited within these types of annuities is not guaranteed, and can fluctuate both up and down along with the open stock market.

    An Indexed Annuity is a type of annuity that many people refer to as being an interesting “middle ground” between Fixed and Variable Annuities.  Indexed Annuity are technically fixed annuities, since they contractually guarantee the safety of the client's principal; however, they give the client the ability to index their gains to a particular stock index instead of receiving only the standard fixed interest credit offered by traditional fixed annuities.  The attraction to the investor is that index annuities can provide opportunities to enjoy higher growth potential than traditional fixed annuities, while still protecting2 their principal against the type of downside market risk that you find in Variable Annuities.

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