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What Is An Annuity?

Annuities are a type of financial product designed to secure a source of income in retirement. Although there are numerous types of annuities, they all share the same basic mechanism: a policy is purchased—either through a lump sum or periodic premium payments—and then, at some point in the future, benefits are triggered. How much the benefit payments will be and how long they last will depend on the type of annuity purchased, the period between purchase and distribution, and additional features.

Why Do Individuals Seek Out Annuities?

Annuities may appeal to consumers for a few main reasons:

  • Obtain a regular source of retirement income
  • Some annuities feature a tax-deferred cash value component, allowing for greater compounding before benefits are trigger
  • With a lifetime income rider, an individual can gain a source of income that cannot be outlived

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Types of Annuities

Although there are many different kinds of annuities, all designed to meet specific objectives, there are two basic types: immediate and deferred.

Immediate Annuities

Immediate annuities are purchased with a lump sum payment. The benefits are triggered shortly after, within a year of purchase. These types of annuities may appeal to consumers looking to convert a sum of money into a steady, regular income in retirement. Because they are purchased with a one-time payment and triggered soon after purchase, these annuities are often referred to as “Single Premium Immediate Annuities.” They do not feature a cash value accumulation vehicle.

Deferred Annuities

This category of annuities are deferred in two senses:

  • First, in contrast to an immediate annuity, deferred annuities involve a period of deferral. During this time, the cash value account grows according to a specified rate or structure.
  • Second, this accumulated value grows tax-deferred, which means that gains compound before distribution.

Within the larger category of deferred annuities, there are many different versions available. Among carriers and contracts, the specifics will vary, but below you will find common types of deferred annuities.

Fixed Annuity (FA)

Sometimes referred to as a traditional fixed annuity or traditional annuity, these products grow value at a fixed rate. A fixed annuity may appeal to an individual who wants steady growth and consistent benefit payments.

Fixed Indexed Annuity (FIA)

In a fixed indexed annuity, the cash value growth component is tied to the performance of a stock market index, such as the Dow Jones Industrial Average. Only positive gains are captured; negative performance is not. Should there be negative movement, the cash accumulation account won’t lose any value. A fixed indexed annuity may appeal to an individual desiring upside potential with guaranteed income.

Deferred Income Annuity (DIA)

Deferred income annuities share elements of both immediate and traditional deferred annuities. DIAs are purchased with a lump sum of money (ala SPIAs) but involve a period of deferral (ala FAs or FIAs). The longer the deferral, the more benefits grow before triggering benefits. Deferred income annuities are usually structured to provide income that cannot be outlived, through a built-in lifetime income rider.

Lifetime Income Rider

The lifetime income rider (LIR) is an important enhancement available with many types of annuities. Sometimes built-in to the base annuity contract, but more often obtained with additional charges, the lifetime income rider provides an individual with a source of money that cannot be outlived.