What Is an Annuity? How Do I Use It?

Written By Jeff Hindenach
Last updated November 24, 2019

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January 21, 2016

Simple. Thrifty. Living.

Annuities are one of the lesser talked about investment options, which can make it a mystery to some people, but annuities are actually a great way to save for the future.

Insurance companies are usually responsible for the sale of annuities, which are financial products sold to people who want to ensure enough money is available to them for the rest of their lives. This might mean an immediate lifetime annuity which can be considered as a pension-type annuity.

In this case, the insurance company is guaranteeing the annuity holder a monthly income for the rest of their lives. In turn, the person who wishes to invest in the annuity makes a single lump-sum payment.

On the other hand, for someone else, a more appropriate annuity might be the deferred annuity. Here, the individual will pay a specific amount annually over a fixed period into a tax deferred annuity.

Once the fixed term has been concluded, the annuity holder can then transfer the accumulated funds over to a different financial product, or they can utilize the tax deferred money and make a single payment towards an immediate lifetime annuity.

At some stage everyone wants to either retire or to at least reduce the amount of working hours they commit to. Previously, many people were able to depend on a company pension to support their financial needs upon retirement, but more recently, this has become less likely. Annuities offer the investor the option to receive a steady monthly income upon retirement. It is an alternative to the traditional IRA or 401K.

There are three basic types. The first of these is the fixed annuity, which is also known as an immediate or traditional annuity. This is the oldest type. The fixed annuity, at its most basic, can be said to resemble the classic pension.

The second type is an indexed annuity. The indexed annuity gets its name because it is tied to a stock index. For example, the S&P 500 Composite Index. This form of annuity allows the owner to potentially make more income from the product purchased simply because if the price for that product goes up, in this case the S&P 500 Index, then so do the financial benefits on offer to the annuity holder. However, there is a cap on the maximum. On the other hand, should the Index go down, the buyer will still receive a minimum rate previously agreed upon.

Finally, there is a variable annuity. This product is more suited to those with a higher tolerance to risk because the initial investment is made into vehicles that are decided upon by the investor. Furthermore, there is no guarantee on a minimum interest rate.

Nevertheless, a number of variable annuity products do have the facility whereby the investor can use a portion of the earnings from the annuity to then invest in a fixed minimum interest account which is held within the annuity. The options for investment with a variable annuity are normally mutual funds that invest into bonds, stocks and various other money market instruments, and therefore, these type of annuities are regulated by the Securities and Exchange Commission (SEC).

There’s no exact way to determine this. However, by using a trusted and knowledgeable financial advisor, it’s possible to find the right product that is best suited to the investor’s requirements.

It is recommended to establish early financial goals, and an annuity should only be purchased if the investor has either already fully funded their IRA, 403(b), or 401(k) for that year, or they intend to do so. This should always be the first step to making plans for the future.

Once those “before tax investment” vehicles have been utilized and if there are still funds available to invest, the annuity can make significant advantages available which can complement an investment portfolio.

If an investor already has a specific idea as to which annuity to invest in, then they are advised to contact their insurance company directly as the insurance company may then be able to recommend a good advisor.

In a sense, there are two parts to this question:

How much is the financial advisor paid?

The financial advisor will be compensated by the insurance company, so there is no fee.

How much are the fees associated with the investment into an annuity?

Most annuities do have associated costs or fees involved, although these often may be lessened or possibly even eliminated if a good financial advisor is used.

An example of how the fees could be lessened is when a person may wish to purchase an annuity to include their spouse or perhaps a significant other. When the investor dies, there could be a fee generated, or the amount of money received monthly may reduce. Either scenario might be suitable to the investor, or the financial advisor may recommend the purchasing of a life insurance policy to ensure the spouse or significant other is taken care of when the annuity holder dies. In effect, this will either lessen the fees involved, or provide for increased monthly payments which are received under the annuity.

About the Author

Jeff Hindenach

Jeff Hindenach is the co-founder of Simple. Thrifty. Living. He graduated from Bowling Green State University with a Bachelor's Degree in Journalism. He has a long history of financial journalism, with a background writing for newspapers such as the San Jose Mercury News and San Francisco Examiner, as well as writing on personal finance for The Huffington Post, New York Times, Business Insider, CNBC, Newsday and The Street. He believes in giving readers the tools they need to get out of debt.

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