| Topic - Annuities A-Z | Education Center |
If you're confused about annuities, you're not alone. Many people have difficulty understanding them. The main reason for all the confusion: Annuities may be deferred or immediate. Both are financial contracts you make with an insurance company. However, a typical deferred annuity helps you accumulate money, while a typical immediate annuity provides you with a steady stream of retirement income in return for your purchase.
Although you put money into both types of annuities, the difference is when you start receiving money from them. Just as the names imply, you get money soon from an immediate annuity and you delay getting money from a deferred annuity.
Deferred Annuities
Deferred annuities can be a great way to accumulate money for retirement, particularly if you have many years before retirement. Your money grows tax deferred, which means you pay no taxes on earnings until you begin to withdraw your money.
There are two basic types of deferred annuities you can buy -- fixed and variable. Between them they offer a variety of funding options.
Fixed annuities earn a guaranteed rate of interest for a specific time period, such as one, three or five years. Once the guarantee period is over, a new interest rate is set for the next period. This guarantee of both interest and principal makes fixed annuities somewhat similar to Certificates of Deposit (CDs) purchased from a bank. Unlike a typical CD, however, an annuity is not backed by the Federal Deposit Insurance Corporation (FDIC); its security is directly related to the financial health of the company that sells the annuity.
You can purchase a fixed annuity in two ways:
Variable annuities typically offer a range of investment or funding options. These may include stocks, bonds and money market instruments. Variable annuities are uncertain compared to fixed annuities. Your principal and the return you earn are not guaranteed; they depend on the performance of the underlying funding options. If the funding options you choose for your annuity perform well, they may exceed the inflation rate or fixed annuity returns. If they don't, you may lose not only prior earnings, but also even some of your principal. Some variable annuities offer a fixed account option that guarantees both principal and interest, much like a fixed annuity. That gives you the option of dividing your money between the low-risk fixed option and higher risk vehicles such as stocks, all under the umbrella of just one annuity. Variable annuities are usually sold on a flexible payment basis, as opposed to a one time lump-sum investment.
Immediate Annuities
Immediate annuities can provide dependable security: a stream of income payments that will continue for the rest of your life, or for a period you select. If you are about to retire, an immediate annuity may be a good place to put a large lump sum of money accumulated through a deferred annuity, a retirement plan or other savings vehicle.
To purchase an immediate annuity, you make a one-time payment, and distributions typically begin within a month. Immediate annuities can be fixed or variable, just like deferred annuities. The income payments you receive from fixed immediate annuities are based on the amount you contribute and the interest rate environment at the time of purchase which will not change. The payments from variable immediate annuities fluctuate based on the performance of the investment options you chose. Although payments may go up and down, variable annuities are designed to provide income that you hope will rise over time to help you keep pace with inflation.