Annuities are an investment product where a contract is made between an insurance company and investors. Under this contract, the insurance company has an obligation to make regular payments to the investor in accordance with the terms defined. The investor is also called the annuitant. Aside from the investor, the annuitant could be the spouse or other beneficiary assigned by the investor. Annuities can be beneficial since they can provide income stability and help smooth consumption. So, in a nutshell, what is an annuity? It is a long-term instrument commonly used in the process of retirement planning.
The investor invests money in an insurance company with the expectation of receiving payments in the future. Usually, the payments are expected to be received during retirement.
Some annuities can provide certain tax benefits because the tax is deferred until the funds are withdrawn. As a long-term investment, there are certain limitations when withdrawing funds before the agreed period. When funds are withdrawn, the company can charge a penalty. When investing in annuities, investors can decide to pay one single payment to the insurance company, or make regular payments. There are no limits in regard to the amount of money an investor can put into annuities. Consequently, depending on the contracts, the investor could also receive one lump-sum payment or multiple future payments. One major disadvantage of annuities is high fees and the fact that the money is not easily accessible unless the investor is willing to pay a withdrawal fee.
Basic types of annuities
With variable annuities, investors can decide where the funds will be invested. Consequently, the return and the payments will depend on the investment types and the relevant costs. Variable annuities bear investment risks, meaning that the investors could end up losing money during a market downturn.
Fixed annuities are characterized by a specific interest rate and a fixed amount of payments in the future.
Indexed annuities are a type of fixed annuity, offering the potential to generate higher returns based on the direction of the index movements. The advantage of this type is that the principal amount is protected from negative movements in the market and the investor. Though It should be understood that there is a maximum potential return an investor can make as there is a cap rate on the return. Thus, even when the index provides high returns, the maximum return an investor will receive is defined by the cap rate.