An annuity is a type of investment offered by life-insurance companies. Individuals invest money over a period of time (known as the deferral phase), and the insurance companies invest this money on their behalf in order to increase their capital. When the time for the annuity to pay out comes (the annuity phase), the insurance company pays out either a lump sum or a set amount each year until the claimant’s death. The latter option provides a guaranteed income for life, but is no longer a popular use for annuities.
There are essentially three different types of annuity: fixed annuities, variable annuities, and indexed annuities. Let’s begin by looking at variable annuities:
A variable annuity involves some element of risk for the investor but also has the greatest earning potential. Investments take the form of either a single initial payment or a number of investments over time. Investors can exercise some control over the risks involved by selecting different types of equity. Many variable annuities allow investors to switch over to a fixed annuity at any time. This gives them yet more control over the amount of risk they take — if the annuity performs poorly, they can switch over to the fixed option sooner. If, on the other hand, the returns are large, the investor can choose to ride it out for a while and maximize their gains before switching over to a fixed annuity to guarantee the payment(s) when the annuity matures.
An indexed annuity’s characteristics effectively hover between those of fixed and variable annuities. The annuity’s performance depends on how strongly a given stock market performs — that is, the annuity is indexed to the value of that market. Some guarantees are also usually provided, giving it part of the character of a fixed annuity.
So by now you’ll have guessed it: Fixed annuities are the safest. And the price you pay for that security is that your returns are never as large as with variable or indexed annuities. The safety feature in a fixed annuity is the guaranteed minimum interest rate. The rate you receive can still vary, but cannot usually fall below 3%. Fixed annuities are normally started with a single payment, and the investor receives their payout after a period of up to 10 years.