Annuities are life insurance policies that give you living benefits. Some annuities provide you with an immediate income stream, while deferred annuities grow for a number of years before turning your nest egg into a pension-style income source. Most annuity contracts include optional features known as riders. While you can't control the performance of an annuity contract, you can use riders to maximize your gains and reduce your losses.
Whether you buy an immediate or a deferred annuity, the size of your monthly income payments depends on the contract's income value. With an immediate annuity, your income value is the amount you invested in the account plus a fixed interest payment that is added to your contract at the time of your investment. With a deferred annuity, your cash is invested in fixed-interest accounts or mutual funds for a number of years. The income value is the actual cash you have in your account when the investment term ends. Your monthly income payments are calculated by dividing your contract's income value over the course of your life expectancy or across a set number of years.
In a stock market downturn, mutual funds held inside an annuity can lose value. Riders are basically insurance contracts that protect you against losses. You can buy riders that assure you of a certain income value even if the stock market drops in value. If you invest $100,000 in your account, you can buy a rider that assures you of an income stream based upon a $100,000 account value, even if your account is worth nothing at the end of the investment term. You can also buy riders that lock in your gains so your account doesn't drop in value during the next market downturn. Other riders assure your pay-on-death beneficiaries of a certain payout in the event that you die before accessing your funds.
Like any insurance contracts, you pay for riders by making annual premium payments. These payments are deducted from your contract value. The more riders you add to your account, the more you pay. You also have to pay standard account fees and mutual-fund investment fees. All things considered, you may end up paying annual fees and premiums that amount to 3 or 4 percent of your contract value. If your account only grows by 2 or 3 percent each year, then the fees could offset your actual earnings.
Many annuitants don't realize the fees involved in annuity contracts, because income riders assure them of a certain return regardless of the impact fees and stock market downturns would ordinarily have on an account. However, when your annuity contract reaches maturity, you can choose to cash in your account rather than convert it into an income stream. When you cash in your contract, you get the cash that's actually left in the account. Riders don't protect you against fees or market downturns when it comes to cashing in your account. If you plan to use an annuity to create a lump sum rather than an income stream, then you have little need for most riders.