What is an annuity and how does it work?

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Types of annuities

You can break down annuities into three types:

Fixed annuities

A fixed annuity is the most predictable option. This is because you get a guaranteed payment that remains constant throughout your ownership. Whether you receive money from it monthly, quarterly or annually, this will never change for you. Plus, you receive a fixed amount of interest with your annuity that doesn’t change beyond the terms of your contract.

When the contract ends, you can make it profitable, renew it or transfer the money elsewhere.

Since fixed annuities come with a guaranteed interest rate, they are not affected by market volatility. This means that you will always know the exact amount of your scheduled payment.

Fixed annuities are subject to regulation at the state level. They also usually come with lower commission fees than other annuities.

Indexed annuities

Indexed annuities are a happy medium between their variable and fixed counterparts. It guarantees a specified rate of return, any return above that tied to an index like the S&P 500. Assume the index is performing well. Then you could earn more money on your next annuity payment. But even if it malfunctions, you will still receive your guaranteed amount.

However, there is a cap on your potential winnings. In addition, only a certain percentage of your income is protected in the event of a market downturn. There are therefore more risks than a fixed annuity.

The Securities and Exchange Commission (SEC) regulates all indexed annuities that are securities. However, the state insurance departments regulate them all.

Variable annuities

Variable annuities are tax-deferred annuities where you can invest your money in sub-accounts with the annuity contract. They behave similarly to mutual funds, which means they depend on market performance. Therefore, they also have a higher risk than some other types of annuities.

Typically, the annuity company offers you a guaranteed return of premium (ROP), so you won’t lose your base investment. However, you cannot earn additional growth if the portfolio is performing poorly. You can receive your periodic payments immediately after funding the portfolio or after a deferred period.

Variable annuities generally come with higher fees and costs than fixed annuities. They are regulated by the SEC.

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