Annuities can be quite complicated and it is often hard for the average person to understand the ins and outs of this type of investment. The good news is it is not necessary to understand every detail of the various types of annuities to realize the investment benefits that can be offered for a certain class of people. In fact, there are some amazing advantages available from this investment vehicle.
Annuity Basics: You pay into an annuity every month and the value of the annuity grows as you do according to an interest rate. Eventually, the annuity matures and begins to pay out rather than you paying in — and it continues to pay out for the rest of your life.
As an oversimplified example, if you put $50/month into an annuity every month from when you were 20 until you were 65 and the annuity had a simple fixed interest rate of 2%, you would have deposited $27,000 and the annuity would have an actual value of $43,805. At that point, the annuity matures and pays out based on your expected lifetime.
If the insurance tables indicate that you’re likely to live for another 25 years, the annuity would pay out $185.67/month every month for the rest of your life. If you perish sooner than expected, the insurance company pockets the difference; if you survive longer, you purely profit.
Playing the Market: The investment part comes in with the invention of ‘fixed-indexed’ annuities – these are annuities that, rather than a fixed interest rate, have a rate tied to that of the stock market. As the economy blooms, the annuities grow quickly but because annuities are a retirement tool and thus need to be safe, the ‘fixed’ aspect assures that there’s a minimum interest rate attached as well.
The upshot is that the annuity will perform according to either the fixed rate or the rate tied to the stock market (indexed rate), whichever is greater. This ability to ‘play the market’ and realize a more comfortable retirement with no chance of loss is an enormous advantage to risk-averse people who want to see the benefit of the stock market’s recovery and resurgence, but also want to protect themselves from down cycles in the market.