What is An Annuity?
Technically speaking, an annuity is a series of payments made at regular intervals. Whether you’re making those payments (as in your monthly mortgage payments) or receiving those payments (as in monthly income from Social Security or a company pension), the payments constitute an annuity.
From a practical standpoint, an annuity is a contract issued by an insurance company, designed either to accumulate cash for a period of time, or to pay out an income stream to the annuitant for a fixed period of time – or for life. Or it can serve both those functions, accumulating cash until, say, retirement and then paying out an income stream for a fixed period or for life.
Annuities can be single premium (a single lump sum of cash is invested in the contract) or annual premium (where cash deposits are made every year). The income can start now (immediate annuity) or in the future (deferred annuity). Clearly, if income is going to start right away, the annuity will be a single-premium contract, and the product is called a SPIA (Single Premium Immediate Annuity).
The income stream can be for a fixed period of time (e.g., 10 years), or with a life contingency. Under the Life Only option, income is paid for as long as you live, but stops as soon as you die. It can be Life with Period Certain – paid for as long as you live but, in no case, for less than the certain period – typically 10 years. It can be Life with Refund – paid for as long as you live, but if you die before your payments total the starting lump-sum amount, the remainder will be paid to a beneficiary either as a lump sum (Cash Refund) or in continuing payments (Installment Refund).
Let’s take a look at the types of annuities available through USA:
As already covered, a Single Premium Immediate Annuity is designed to convert a lump sum of cash into an income stream. Typically, the income payout will be either monthly or annual. If it’s monthly, the first payment will be made one month after the funds are deposited. If it’s annual, the first payment will be made one year after the funds are deposited.
A traditional Fixed Annuity provides an interest crediting rate that is guaranteed one year at a time, but with an ongoing minimum guaranteed rate as well. When the policy is issued the company sets the first-year interest rate which, many times, includes some sort of upfront bonus to enhance the first-year return.
A Multi-Year Guaranteed Annuity (MYGA) – sometimes called a fixed rate annuity – is an annuity issued with a guaranteed interest rate period which is equal to the length of time that surrender charges last. With a fixed annuity, the insurance company pays you a set predetermined interest rate during the time that your account is growing. This fixed interest rate is usually declared upfront and stays in effect for the entire growth period of your annuity. Therefore, regardless of what is going on in the economy as far as interest rates are concerned, you are certain about what your interest rate will be on a MYGA.
These annuities are typically offered with guaranteed rate periods of 2-10 years. Like CDs, there are surrender charges if you take all of your money out before the specific contract period ends, but most MYGAs allow you an annual 10% penalty-free withdrawal if some liquidity is needed.
Fixed Indexed Annuity
With a fixed indexed annuity, the interest that you earn on your account is calculated based on changes in an external index, such as the S&P 500 Composite Stock Price Index, the Dow Jones Industrial Average, or a host of other indexes, up to a predetermined maximum. Indexed annuity contracts also guarantee a minimum interest rate below which your interest credits cannot fall, regardless of the performance of the given index.