Annuities are insurance products designed and sold by life insurance companies. These products guarantee an income to you for as long as you live or for a specific number of years. However, you may defer the guaranteed payment until a time you specify. Either way, annuities always pay an interest rate. The typical rate depends on the type of annuity.
A fixed annuity pays interest based on bonds and bond-like investments. Therefore, the interest rates that are typical of fixed annuities will be interest rates that reflect the fixed rates paid on bond investments. These bond returns fluctuate over time as yields increase or decrease on new bond issues, but the annuity itself pays a fixed rate based on the bond yields at the time of the annuity's purchase.
An indexed annuity uses both bonds and index call options to derive its interest. Therefore, the annuity may pay a low guaranteed rate of 2 percent or less, and then pays an interest rate that reflects only the upward movement in the stock market specified into the annuity policy. The returns on the policy will vary according to the performance of the underlying stock index, but will never be negative.
A variable annuity is an annuity that derives its interest from mutual funds. Mutual funds do not pay a typical rate of return. Instead, returns depend on the specific companies that the mutual fund invests in. Some funds do invest in bonds, but the fund actively trades these bonds so the returns reflect the most current yields and tend to fluctuate with the buying and selling of the underlying assets in the fund.
An immediate annuity draws its interest primarily from income producing assets, like bonds. Most of the annuity's payment is a return of the original investment principal, however, with only a small amount of interest added to each payment. In this way, the interest is spread out over the life of the contract.
- "Life Insurance"; Kenneth Black, Jr., Harold D. Skipper, Jr.; 1994
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004