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An annuity is an investment option that offers an insurance component to individual investors. Annuity investments get their name because the investor has the ability to convert their investment into a set of periodic income payments (an annuity) either over the investor's life or over a set number of years.
There are two main reasons for choosing annuities:
• The guaranteed income stream is important.
• Saving money over the long-term.
These two reasons are why many investors chose annuities to fund their retirements. Some investors also chose annuities to meet other long-term investment goals, such as funding educational costs for their dependents.
Annuities offer earnings that are tax-deferred. Another advantage when compared to other investment vehicles is that annuities do not have contribution or income limits. Additionally, investment swaps, within the annuity's contract, can be made without incurring tax penalties. The insurance component of an annuity offers a premium to investors if they outlive their life expectancy.
To understand the benefits of annuity investments in more detail, it is important to understand the difference between the main types of annuities. There are three fundamental different annuity types: fixed, variable, and indexed annuities.
Fixed annuities have an interest rate that starts out as a fixed percentage. The rate can vary over time. However, the way in which the rate is change is stipulated in the initial contract. Fixed annuities also guarantee investors a certain minimum rate of interest for the annuity's contract period. With a variable annuity, the investor uses their contributions to invest in mutual funds. The annuities payouts are then based on the mutual funds' performance.Â
The final and newest type of annuity is an indexed annuity. These investments are designed to mirror the performance of a financial index, such as the S&P 500. Investors can chose how closely their annuity follows the index's performance, by selecting a participation rate for the annuity.
Fixed annuities are considered a low-risk investment because of the fixed interest rate component of the investment. Fixed annuity investors benefit if interest rates fall, but not if they rise. Variable annuities do not offer a guarantee as with fixed annuities. However, investors in variable annuities have the ability to choose how to allocate their money amongst different mutual funds.Â
Finally, indexed annuities allow investors to track the performance of a financial index. The annuity will usually track the index in a bull market; however, the issuers of the annuity also guarantee a minimum annual interest rate to avoid losses when the index is in a downturn.
In summary, annuities can offer many benefits to the individual investor to meet their long-term investment needs, such as retirement planning. The basic insurance feature embedded into annuities offers a measure of protection for investors against market downturns. Returns can also grow in a tax-sheltered environment until the money is withdrawn. The three basic different types of annuities offer slightly different benefits depending on what is required and what the risk level is of the individual annuity investor.
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