Annuities are insurance products that provide you with an eventual income source. You can buy an annuity with a single purchase premium or with a number of periodic payments. Your contract grows on a tax-deferred basis but your returns depend on the type of contract you purchase and the optional contract features.
When you buy an immediate annuity, the insurance provider converts your lump sum purchase premium into an income stream. Generally, you start to receive income payments within about a month of purchasing the annuity. An immediate annuity has a fixed rate of return. The insurance company multiplies your initial investment by a certain interest rate. You cannot make a lump sum withdrawal but you do get your principal and interest over the course of the annuity term. Insurance firms sell contracts with terms lasting for five, 10 and 20 years or even for the duration of your life. Normally, you get the best rates on the contracts with the longest duration.
As the name implies, a fixed annuity is an insurance contract on which you earn a set rate of return. Fixed annuities are deferred, which means your contract grows for a number of years before you can begin to make withdrawals. Some contracts have a fixed rate for the entire term while other contracts offer an introductory fixed rate that changes after the first year. Insurance companies invest your premium payments in low-risk securities such as government bonds. Consequently, yields on newly issued fixed annuities tend to rise and fall in line with interest rates on mortgages, bonds and other securities.
An indexed annuity is a deferred annuity on which your returns are based upon the performance of an underlying index such as the Dow Jones Industrial Average. You make money if the index rises over the course of the annuity term, although in many instances your returns are capped. If the index loses value you normally get back 80 percent or 90 percent of your original investment. However, many contracts include a clause entitling you to a fixed rate of interest on the portion of your principal that you get back. If you buy a $100,000 indexed annuity with a clause entitling you to a 90 percent return of principal in a down market then you would get back $90,000 plus some interest on that sum of money.
Variable annuities are deferred contracts through which you buy shares in mutual funds. Your contract's final value is entirely dependent on the value of the shares held within the contract. If you lose money on a variable annuity, you usually have the option of getting your initial investment back but only in the form of a series of periodic monthly payments. Unlike equity-indexed annuities, variable annuities are not subject to earnings caps. Therefore, your returns are potentially unlimited although you do pay annual fees that erode your returns.