What Are Annuities and How Do They Work?
When it comes to your retirement plan, you may have dismissed fixed annuities as overly complicated. But with major benefits to be had, we think investing in an annuity is a conversation worth having.
In this post, we’re taking an in-depth look at fixed annuities, including what they are, how they work, and the different options available. We’ll also walk you through an example, so you can see how this type of annuity could benefit your retirement fund.
Annuities – a quick refresher
In part one of our ‘Annuities – Why Ever Use Them’ series we covered the basic what, why, and how of annuities. If you missed it, here’s a quick refresher:
- An annuity provides income in retirement, either as a stable income stream or as a place to earn interest on your money
- People take out annuities for one of two major reasons: income planning in retirement and as a safe place to store money
- There are two major types of annuities: immediate and deferred
- An immediate annuity is when you give a lump sum to an insurance company, which then distributes it back to you through income-for-life payments
- A deferred annuity is a place to invest and store money for your retirement. You can earn interest on the money you’ve invested before withdrawing it as a lump sum or setting up an income stream
- There are two major types of deferred annuities: fixed and variable
We always recommend the fixed-rate option, so that’s what we’ll focus on in this post.
If you’d like more information on the basics of how annuities work, be sure to watch part 1 or listen to our podcast episode.
What are the main types of deferred fixed annuities?
If you’re looking for somewhere to store your savings and make money, a deferred fixed annuity could be a good option. This is when you give a lump sum to an insurance company to earn interest on your retirement fund.
There are a couple of benefits to fixed annuities which make them more attractive than immediate annuities. Firstly, the money you give to the insurance company isn’t locked away, so you can access your savings for big purchases, like vacations or home improvements.
Secondly, you’ll earn interest on your investment, giving your retirement pot a significant boost without fear of losing your principal investment.
The amount of interest you earn will depend on the fixed annuity you invest in, with the two main types being declared rate and fixed index. Let’s take a closer look at how these annuities work and what they offer.
Declared rate annuities
A declared rate annuity provides a fixed rate of return over a set period. Think of them like a certificate of deposit (CD), wherein you consistently earn interest in a safe, stable way.
Declared rate annuities are a popular option for those who want to boost their retirement pot with a reliable source of interest. At the end of the plan, you can withdraw your money and walk away or set up an income stream for your retirement years.
Of course, the downside to declared rate annuities is that the amount of interest is fixed, so you’ll never make more than the declared amount. While this does mean reliable earnings, it takes away the opportunity to make money when the markets are up, so you’ll miss out on a potentially higher rate.
Fixed index annuities
Fixed index annuities bridge the gap between fixed-rate and variable annuities, allowing you to benefit from market upswings without fear of losing your principal investment. With this type of annuity, the interest you earn is based on an index, be it the SMP500 or the NASDAQ.
Having your retirement assets linked to the stock market might sound alarming, but the beauty of this type of annuity is that your investment is guaranteed. That means you can take advantage of higher interest rates when the market climbs, without fear of losing money should it fall.
The drawback to fixed index annuities is that when the market is negative, you could make little to no interest over a 12-month period. However, if this is a risk you’re willing to take, the interest you earn when the index goes up will more than likely outstrip that of a declared rate plan.
How is interest credited on a fixed index annuity?
So, how does the interest you earn through an index make its way to your retirement fund? To answer that, we’ll set out a basic example of a fixed index annuity, so you can get an idea of the numbers and timeframe.
Let’s say you invested $100,000 in a fixed index annuity on January 1, 2020. Over the next 12 months, you’ll earn interest based on how the index performs.
On January 1, 2021, the annual reset occurs, and you’ll receive your first statement. This tells you how much interest you’ve earned from the index as a percentage sum.
So, if you made 5% interest, your investment would now be worth $105,000. This is the amount that you start the new earning period with, and it’s guaranteed money that you can’t lose, even if the market declines.
Say, for example, the index performed poorly for the next 12 months; you wouldn’t make any money, but you wouldn’t lose any either. That’s why fixed index annuities can be a powerful way to boost your retirement fund and guarantee a good rate of return over the earnings period.
We understand that the annuities world can be complicated. That’s why we plan to continue this series, walking you through the ins and outs of the different options available.
Remember, if you need any advice or expertise in setting up an annuity for your retirement, our financial specialists are here to help. Book a complimentary 15-minute call with a member of our team to discuss your retirement goals today.