Now that you're settling in to your new life, you and your spouse have begun thinking about your future. You realize you should start saving, and looking at financial products, you are torn between an annuity or a compound-interest product such as a certificate of deposit, or CD, or savings account. Though you want to ensure that you can't lose what you've invested if the economy should take another downturn, you also want to get the most bang for your buck.
If one of the investment options you are considering is an annuity, it's important that you know exactly what one is, the risks and the potential earnings. Simply put, an annuity is an insurance product that produces a guaranteed income stream to you for retirement in exchange for regular premium payments during your working life. There are several different types of annuities, each with its own benefits and risks. It's important that you choose the type that best fits your situation.
Types of Annuities
Annuities come in three types -- fixed, equity-indexed and variable. Of the three types, fixed annuities are the safest. They are invested in government and corporate bonds. The interest rate is set each year by the insurance company, but they usually have a guaranteed minimum interest rate. You cannot lose your principal with this type of annuity. Equity-indexed annuities are riskier than fixed annuities but can offer higher yields. These offer fixed terms with an index set at the start of the term based on changes in returns on stocks, bonds and money markets. Typically, they offer you a 30-day window at the end of the term to cash in the annuity with no surrender penalty. A variable annuity is the riskiest because you can lose your initial investment if there is a downturn in the annuity's portfolio. They are invested in stocks, government securities, money-market funds and mutual funds containing stocks and bonds. Though it has a higher yield if it's performing well, don't make a variable annuity your only investment.
Often attributed to Albert Einstein, perhaps erroneously, is the observation that "The most powerful force in the universe is compound interest." With compound interest, even if you invest only one dollar, your money will continue to grow even if you don't add a dime, because as you earn interest, it is added to the principal and your future interest is earned on that compounded amount. Aside from the intrinsic advantage of compound interest, if you put your money in an FDIC-insured savings account, you can't lose your initial investment and you have ready cash available, without penalty, should you need it. A CD also offers compound interest, but you will pay a penalty for withdrawing it prior to the end of the term.
Which to Choose
If you have no other savings and are just starting out, you are better off with the compound interest option as your initial investment. You will have access to your cash if you need it and you can't lose your money. Once you have an established savings account, you can move into the annuity arena, but keep in mind that if the stock market is doing poorly, you may end up earning less with the annuity than you do with a savings account or CD. As your lives change, you can, and should, adjust your investment strategy.
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