The Three Most Common Annuities Explained

The world of financial and insurance products can seem to be an endless sea of terms and definitions.

The average investor is often left in a world of confusion, not really knowing what to learn next.

This steep learning curve can be discouraging, leaving the investor unable to make decisions and jeopardizing their hard earned money.

To help clear some of the air regarding one of the more confusing insurance topics, we have put together a short and sweet guide so that you have the 3 most common annuities explained.

The Annuity Explained

The first thing that needs to be addressed is the term annuity. An annuity is explained in simple terms by talking about how it works.

The annuity is an insurance contract between a buyer and an insurance company.

The buyer purchases an insurance product with premium payments and the insurance company guarantees a return on the owner’s payments.

The term annuity refers to the payment structure to the insurance policy owner’s beneficiary. To annuitize a payment is to make it over a period of time, or to break it into multiple payments.

For example, if you were to annuitize $100 dollars over 10 years with no growth from interest, it would pay out a total of $10 per year for 10 years.

To fully explain annuities, you must talk about all of the different options and types of annuities. We will talk about the three most common annuities in the subsection below.

There are also a couple of other distinctions that you should be aware of. The two types of annuities that almost all annuities will fall under are deferred and immediate.

A deferred annuity is explained as an annuity that begins payments to the beneficiary at a later date in time.

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An immediate annuity is an annuity contract that begins payments to the beneficiary one period after the date of the creation.

The period is usually monthly or yearly, depending on the terms of the contract.

A couple of quick annuity terms explained:

Account Owner – the person that purchased or owns the account.
Annuitant – the person whose life is covered by the account. In the case of a life annuity, the annuitant is the person whose life determines the duration of payments.
Beneficiary – the person who receives the payments from the insurance company.

Variable Annuities Explained

Variable annuities are explained by the term variable. Rather than having a fixed payment amount, the variable annuity is based upon a variable account value or interest rate.

Most often the variable account is in some way tied to market trades and as such can gain or lose value based on performance of the investment portfolio.

The size of the payment to the beneficiary is variable and can be swayed by market changes.

Equity Indexed Annuities Explained

Equity indexed annuities are explained in a similar fashion as variable annuities; however there are some key differences.

The equity indexed annuity more closely resembles a fixed annuity.

As the name implies the equity index annuity is tied to the performance of an equity index such as the S&P 500 or the Dow. Where a variable annuity contract can lose value, an equity indexed annuity never will.

The equity index annuity is designed to only participate in market upswings, and provides a guaranteed minimum return during market downswings.

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This type of annuity allows for protection of principal as well as growth from market increases.

The reason insurance companies can offer this type of contract is that they will either cap the growth rate on up years or only allow participation of particular percentage of the upswing.

Fixed Annuities Explained

Fixed annuities are the most common type of annuity contract. The “fixed” portion of the annuity refers to the payout.

Rather than have a payment that varies as with variable and equity indexed accounts, the fixed annuity remains constant.

It can provide the annuity owner a very predictable structure to the account owner. This type of contract will either make payments for a fixed period of time (10 years, 20 years, etc) or for the lifetime of the annuitant.

Related: Buying a Fixed Annuity

As with any type of financial product, it is difficult to have annuities explained in a very comprehensive way without getting very technical.

Needless to say, there are a number of different variations of annuities types. Each type has its advantages and disadvantages.

Be sure that you fully research some of the pros and cons of annuity contracts before jumping into a purchase.

Most annuities are difficult to reverse once they have been funded, and carry steep penalties if you need your money faster than you anticipated.

It may be best to have annuities explained to you by a professional that can also analyze your financial needs.