Annuities aren't the most glamorous of investments. In fact, they're about as dowdy and conservative as retirement planning can get. They're an insurance company's investment product -- basically a life insurance policy that's had its plumbing rearranged to produce income. Annuities are not ideal for every financial plan, but when chosen correctly they can be extremely useful. It's important to understand how fixed and variable annuities work, as well as more specialized products such as short-term annuities.
Instead of charging you premiums for a long time and then paying out a lump sum, like life insurance, an annuity takes your retirement nest egg and turns it into a stream of long-term payments. You typically build that nest egg by making monthly contributions to the annuity -- just like an insurance premium -- and the insurer invests the capital on your behalf. Your money will grow tax-free inside the annuity, until you start to withdraw an income. The annuity can be either "fixed" or "variable," depending where you sit on the risk-vs.-reward question.
If annuities were cars, a fixed annuity would be your grandfather's big old sedan. Fixed annuities might not produce mind-boggling returns, but they are safe. Your money goes into the insurer's in-house portfolio, which is invested in stodgy, reliable products such as treasury bills and high-quality bonds. The insurer offers a guaranteed rate of return, which will be reset periodically over the years as interest rates go up and down. When you retire with a fixed annuity, the insurer guarantees your retirement income either for life or for a set period, whichever you prefer.
Variable annuities are for investors who are open to a bit more excitement in their investments. Instead of using the insurer's in-house portfolio, variable annuities invest in mutual funds and similar products. When things go well, a variable annuity can bring you much better returns on your money. When things go poorly, you can lose your money. That's what makes them variable.
Fixed vs. Variable
Both fixed and variable annuities have their pluses and minuses. Fixed annuities are about as safe an investment as you can make, and their returns are usually higher than other guaranteed products such as CDs. Unfortunately, inflation will eat into your annuity's spending power, especially during times of low rates. Variable annuities can make you more money, but they also put your investment at risk. One traditional strategy is to use variable annuities while you're young and have decades to make money, then switch to a fixed rate when you retire and need stability.
Most annuities provide retirement income for life, or at least an extended period of time. But a few specialized annuities are designed for short-term use over three to five years. They're a sort of super-CD for investors who want to have a "bridge" income for a specific reason. For example, if interest rates are low, you might hold off on locking in your fixed annuity and get a short-term annuity instead. When rates go up, your fixed annuity's rates -- and payouts -- will improve. Your annuity will also pay more if you lock in at an older age, and a short-term annuity can help you do that as well.
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