An annuity is a contract with an insurance company to pay a certain amount of money, usually every month, and in most cases for the life of a person called the annuitant. The money is generally paid to the annuitant, although it can be paid to a third party. It's the annuitant's life, though, that is used as the basis for calculating the amount of the monthly payments. And of course, a payment -- the premium -- is made to the insurance company in order for it to make those monthly payments. Whatever money the annuity makes is tax-deferred - that is, taxes are not due until the funds are actually disbursed.
Types of Annuities
Those are the basics. Nearly everything about an annuity can be altered or amended, with a single exception – the annuitant must always be a human being. The payments can start immediately, in which case it's called an “immediate annuity,” or they can start at some time in the future, in which case it's a “deferred annuity.” The payment to the insurance company can be a lump sum, or it can be periodic. The annuitant doesn't have to be the owner of the contract – it can be owned by a third party, either a natural person or a business or other organization.
The overwhelming majority of annuities are deferred annuities – that is, the monthly income stream doesn't begin immediately, but is deferred until some point in the future, usually unspecified. Between the time of purchase and the beginning of the monthly income stream, the annuity will grow in value via the accumulation of interest.
When it comes to how interest is calculated, annuities can be divided into two broad groups, variable and fixed. Variable annuities' principal is invested in securities and can be lost to market fluctuations – in fact, anyone selling a variable annuity in the US needs a stockbroker's license to sell such a product. The other type of annuity, a fixed annuity, doesn't carry with it the potential for loss of principal, and can be sold by an insurance agent.
Fixed Index Annuities
There are two types of fixed annuities – fixed rate, where the interest rate is declared and paid by the insurance company annually, and fixed index, where the interest earned is based on the performance of a stock market index such as the Standard & Poor's 500. The fixed index annuity is also known as an equity index annuity.
A fixed index annuity's interest rate isn't known until the end of the period being measured, because it's based on the performance of an index fund. Usually annual, and based upon the initial purchase date of the annuity, if the index increases over the period from what it was at the day the annuity was purchased (or the day after, in some cases), then the annuity earns interest at a rate based on the gain in the value of the index. If the index loses value, though – and this is crucial to understand – then the fixed index annuity doesn't lose anything – its value doesn't decline, but it also doesn't increase.
While not earning interest over the course of a year, those investors who invested in an actual index fund for the same index – say the S&P 500 – over the same period would actually lose principal. Thus, what the fixed index annuity does is guarantee the benefits of the market without imposing any of its drawbacks. For people who are risk-averse, such as those approaching retirement within ten to fifteen years, a fixed-index annuity, whose greatest drawback is the possibility of not earning interest in any particular year, is far preferable to an investment which could lose value, which is what could happen if the money were invested directly in the index fund.
The "Ratchet and Reset" Principle
Once interest is credited to a fixed index annuity, it becomes part of the principal amount on which the next year's interest payment will be calculated, and cannot under any circumstances be lost. This is called the ratchet and reset principal - the annuity's value is ratcheted up and then reset at that higher value. By comparison, money invested in a mutual fund or stock index fund, once credited to the principal balance, is just as vulnerable as the rest of the principal.
A fixed index annuity, then, is an insurance product whose principal can never be lost to market fluctuations because it's not invested in the market. When the index increases in value over the course of a year, the annuity earns interest based on the increase in the index's value. If the index loses value, the fixed index annuity neither declines nor increases.
Why Fixed Index Annuities are Important to Investors
And here's the reason anyone with money to invest should care about fixed index annuities: although fixed index annuities are much more conservative than investments in index funds, mutual funds or even bond funds, surveys of actual performance since the early 1990s shows them to have outperformed virtually every other investment available.
NEXT: How the Power of Loss makes Fixed Index Annuities such a great investment!
Dale Marshall - After a fairly long, often rewarding and frequently frustrating career in the corporate and semi-corporate world, I passed age 45 and ...
