How Does An Annuity Work?

The first question you’re likely to ask yourself when entering the annuity universe is how does an annuity work? The answer to this question depends on the type of annuity program you select. There are generally three broad categories of annuity, each working a bit differently: fixed, variable, and equity-indexed.

There is also a distinction between how annuities disperse income. Deferred annuities accumulate income over time, while immediate annuities provide a stream of income, typically within a year of the contract’s purchase. For help choosing the best type of annuity for you, vist the link below:

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Types of Fixed Annuity

A classic is the single premium immediate annuity (SPIA). This is a fixed annuity requiring a lump sum payment to an insurance firm for the promise of return of principle within x number of years, plus interest. In a fixed annuity this interest rate is guaranteed for either the full contract term or a signficant part thereof.

Most annuities feature a lifetime option, which allows payments to be maximized for as long as you live. In this case, the payment amount is likely to be greater than returns produced from other kinds of fixed-dollar investments and your income will not run out during your lifetime. On the other hand, if you die after receiving only a few payments under this contract, you will have put in more money than you ultimately received.

The single premium deferred annuity (SPDA) allows for deferred payments instead of immediate income. You make the single lump sum payment to the insurer, but payments to you will not begin until the contract’s maturity date. On this date, you may take the total value of the contract or receive annuity payments.

Some deferred annuity contracts allow you to make periodic payments instead of the lump sum, building up value over time. As you make each payment, the money in your account increases, much like a 401(k). When you reach retirement age (or some other date specified in the contract), payments begin.

Annuity Options

There are different types of pay-in, withdrawal, and investment options available, depending on the kind of contract you select. With a single premium annuity, you invest a single lump sum amount, while flexible premium annuities let you make a minimal investment, with additional investment in the future. Fixed annuities generally use more conservative investment vehicles such as bonds, and guarantee your principal investment and minimum earnings interest rate. Variable annuities invest in mutual funds and bonds, with no principle guarantees. Although variable annuities incur more risk, they also promise greater returns because equities are generally higher-growth.

Federal vs State Annuity Coverage

Because annuities are issued by insurance companies, they are not insured by the FDIC, like a CD or money market account. In the case of a fixed annuity however, this lack of FDIC insurance doesn't make it less secure. Firstly, all annuities are safeguarded by state reserve pools, which cover contracts from $100,000 to $400,000 in case the insurance company issuing the annuity ever become insolvent. Secondly, the security of insurance companies is second only to the Federal government. Well rated insurers are less vulnerable to insolvency than your local bank.

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