It’s no secret pension plans are getting harder to come by. As a result, many Americans who are nearing retirement are turning to annuities to supplement their income streams. Though the common thought of annuities define them as investments, the financial services industry thinks of them more as contracts. With any contract, there is much to consider before solidifying your obligations.
What is an annuity?
An annuity is a contract from an insurance company that helps you obtain certain financial goals such as protection, retirement income, legacy planning, or long-term care costs. Annuities are professionally referred to as contracts because they provide guaranteed income for an agreed timeframe, whereas investments normally do not have the same certainty.
The word “annuity” is so broad that one could consider a social security benefit an annuity. For a concise definition, you make payments on annuities for a set amount of time before the annuities start paying you.
How do annuities work?
One of the most attractive features of an annuity is the consumer control. You choose what you want the money to do and when you want it to start doing it. There are two phases of annuities:
Accumulation Phase
This is when you pay the annuity. Premiums can either come in the form of a lump-sum payment, or a series of payments. Regardless of how you’re paying the annuity, if you’re paying a premium, you’re in the accumulation phase.
Payout Phase
Once you’ve met the total on your premium payments and the time you set on your contract has arrived, you have entered the payout phase. This is when you stop paying the annuity and the annuity starts paying you. However, some annuities can be paid out while you are still contributing to it.
If you have a lifetime annuity, streams are based on your life expectancy. Therefore, if you start receiving income younger, your life expectancy is longer, or your payout period is long, your annuity payments will be small and vice versa.
Why do people buy annuities?
Annuities are mainly popular for those close to, or in, retirement as they help stream income. Annuities provide:
- Frequent payments for a set amount of time such as the rest of your life or your spouse’s life.
- Death benefits to your beneficiary should you die before you start receiving your payments.
- Tax-deferred growth on the income and investments gained from your annuity until you take out the money.
What type of annuities are there?
Annuities is a broad term that can apply to many different income streams, but the most common types of annuities may fall under three categories:
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Fixed annuities are regulated by the state insurance commissioners and they are purchased with a fixed interest rate and fixed amount of periodic payments.
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Variable annuities allow you to invest your payments into different options such as mutual funds. The payment varies depending on the rate of return and expenses.
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Indexed annuities can be considered hybrids, with a combination of securities and insurance products. A return is credited to you based on stock market index. This type of annuity is also regulated by the state insurance commissioners.
With a complex product such as an annuity, it’s vital to understand the role it plays as well as the fine print such as payment schedules, amounts, beneficiaries, and fees. As with any major insurance purchase, it’s encouraged to consult a licensed insurance professional before signing any policies.