Annuity funds determine your rate of return and ultimately your guaranteed income payment amount. This is why it’s important to understand the difference between annuity types and how annuities work. It’s also helpful to have a foundational knowledge of the stock market and other elements of financial literacy, as annuities are only one aspect of a comprehensive financial plan.
Where Does Your Premium Go?
Annuities are categorized as either immediate or deferred and either fixed or variable.
In all cases, you pay a premium for your annuity. The insurance company invests your premium, along with the premiums it collects from hundreds of other annuity owners, and invests it.
Insurance companies are what are referred to in the investment world as “institutional investors.” Institutional investors invest huge sums of pooled money in stocks and bonds to generate returns large enough to allow them to pay out the income streams they guarantee.
The type of investments the insurance company puts your money in depends on the type of annuity you purchase.
Interested in Buying an Annuity?
Fixed Annuity Funds
Fixed-rate annuities provide a fixed payment amount determined in part by the level of risk the company is assuming, as well as the performance of the fixed securities market and the annuitant’s life expectancy.
Single premium immediate annuities (SPIAs) begin paying out within a year of purchase and their payment amounts never change. Deferred annuities begin paying out at a later date and include an accumulation period during which the account value grows as interest is compounded.
The annuity fund for a fixed annuity comprises bonds and other fixed-rate investments into which the insurance company invests the money. Although the fund won’t generate high returns, your money is safe and the insurer will typically guarantee a minimum interest rate for the life of the contract.
Variable Annuity Funds
Variable annuity funds are less stable because they consist of market-based investments. The insurance company gives you control of the subaccounts — the underlying portfolio of funds — allowing you to choose from a selection of bonds and stock options, including money market funds, mutual funds and bonds.
Because variable annuities are tied directly to the performance of the stock market, your rate of return can fluctuate, meaning it is possible for an annuity holder to lose money with a variable annuity.
Riders and Annuity Insurance
Annuities are, in fact, a form of insurance. The annuity contract essentially transfers the risk of you outliving your money to the insurance company. Variable annuities, however, offer less longevity insurance in exchange for growth potential.
For savers and investors hoping to maximize the benefits of this financial instrument, annuities can be customized by purchasing riders that protect against the negative impact of the market. You can think of these additional provisions as insurance within insurance.
For example, a return-of-premium rider can be added to an annuity contract to ensure that the initial investment will not be lost. If you bought a $200,000 annuity and died after collecting only $50,000 of the original premium, this rider would guarantee that your beneficiary would receive the remaining $150,000.
Be aware that the addition of riders or annuity fund insurance will be accompanied by fees that will lower your income payment amounts.
The type of annuity fund — hence, the type of annuity — best suited to you will depend on your financial objectives. Just as you would weigh your goals with your risk tolerance when making investment decisions, you should weigh these factors before deciding on which type of annuity to buy.