Annuities are a means by which a person can purchase a relatively secure income stream during his retirement. Insurance salesmen and companies are the primary pitchers of these products. An annuity can be immediate or deferred, and it can also carry a fixed or a variable interest rate. Due to the low level of risk generally associated with an annuity, the return is not usually high; generally, it will cover the cost of inflation.
Ordinary Annuity Versus Annuity Due
When choosing the type of annuity, compounding interest can play a key role. In an ordinary annuity, the interest accrued during a set period is deposited into the account at the end of the cycle. In an annuity due, it is contributed at the beginning. For the annuity due, that interest can accumulate more interest throughout the current period, whereas an ordinary annuity will not until the following period.
Immediate Annuity Versus Deferred Annuity
Also influencing return is the amount of time the annuity is allowed to accumulate interest earnings. An immediate annuity will begin to pay the investor following her initial deposit. A deferred annuity will not pay until some future date guaranteed in the contract. Therefore, the deferred annuity is going to have more time to earn a return. However, if it is a variable annuity, it will also be subject to the risk of loss.
Fixed Rate Versus Variable Rate
In general, a variable rate annuity is going to offer higher returns over a longer period of time. This is because they are actively managed, meaning the stocks and mutual funds it invests in are periodically changed. A fixed rate return guarantees the owner of the policy an annual return rate. Many times it is around four percent, which will cover the rising cost of goods or inflation.
Return and Costs
The return on an annuity is dependent on the insurance company through which it is purchased, as well as the type that is selected. It is a type of contract that provides assurance to an investor because it guarantees a certain amount of income. However, the returns are not usually significant. A potential buyer should be wary of the costs associated with the purchase of a variable annuity. These costs can be rather significant given the low rate of return, potentially negating the ability to cover inflation.
- "Personal Financial Planning, Theory and Practice"; Kaplan Schweser; 2009
- CNN Money: Ultimate Guide to Retirement
Christine Aldridge is a financial planner who has been writing articles related to personal finance since 2011. She has bachelor's degrees in political science from North Carolina State University and in accounting from University of Phoenix. Aldridge is completing her Certified Financial Planner designation via New York University.