If you own an annuity, the part of your contract that earns returns is called the annuity fund, and it’s important to understand how it works for different types of annuities. In other words, all three of the primary categories of annuities have an annuity fund. Understanding the nature of this fund can help you make better decisions about whether to buy an annuity and, if so, what kind.
Consider working with a financial advisor as you plan for retirement income.
How Annuities Work
Typically, annuities are sold by insurance companies although they can also be sold by financial advisors.
When you buy an annuity, the contract is made between yourself and the company you purchased it from. The terms of the annuity, meaning how much you pay in premiums, how often you pay them and when you begin receiving payments, depends on the type of annuity you buy.
There are three primary categories of annuities:
- Fixed annuity: With a fixed annuity, you’re guaranteed to earn a minimum rate of interest on your money. You’re also guaranteed to receive a fixed number of payments.
- Variable annuity: Variable annuities offer returns based on the underlying investments you choose. For example, a variable annuity might be invested in actively or passively managed mutual funds. Variable annuities can potentially offer higher returns than fixed annuities but they typically carry a higher degree of risk.
- Indexed annuities: An indexed annuity is a way to split the difference between fixed and variable annuities. Returns are tied to the performance of a stock market index or benchmark, such as the S&P 500. An indexed annuity may outperform a fixed annuity but be less risky than a variable annuity.
It’s also worth pointing out that the various types of annuities can be immediate or deferred. Immediate means that the annuity begins making payments back to you relatively quickly, typically within one year of purchasing it. A deferred annuity, on the other hand, might not begin making payments for several years. So, for example, you might purchase a fixed deferred annuity in your 50s with the intention of taking payments starting in your 60s.
In terms of premiums, this also depends on the type of annuity. Some annuities, such as a single premium immediate annuity, are funded with a single large premium payment. Others structure premium payments to occur monthly over time.
What Is an Annuity Fund?
The annuity fund is the part of your annuity contract where returns are earned. How your annuity fund works depends on the type of annuity you have.
With a fixed annuity, for example, the annuity fund may be part of the company’s larger investment portfolio. An asset manager oversees how investments are made and where funds are allotted to produce returns. Remember, fixed annuities tend to be more conservative compared to variable annuities, so your annuity fund may hold things like government securities or bonds as well as stock-based mutual funds.
With a variable annuity, the investment approach is a little different. For example, you may have a heavier weighting of stocks to bonds or have the option of investing in a wider range of mutual funds, including index funds, target-date funds or exchange-traded funds. Depending on how the annuity fund is set up, you may have more of a direct say in which funds you want to invest where.
For instance, aside from increasing your exposure to stocks and bonds you may have the option of allocating part of your annuity fund to safer investments. You might choose to put some of your money into a money market fund, for example, or CDs and bonds that earn a guaranteed rate of return. Mixing things up this way increases diversification, which can help you better manage risk.
Choosing Annuity Fund Investments
Once you know what an annuity fund is, you can think about which type of investments best suit your goals. That goes back to determining whether you’re more comfortable with a fixed, variable or indexed annuity.
For example, all three types of annuities can offer guaranteed income for life. You could also structure your annuity to provide income payments to your spouse for their lifetime if you’re married. A fixed annuity would offer more downside protection against market losses compared to a variable annuity. A variable annuity, however, could offer better growth.
Knowing which one to choose means knowing your risk tolerance and risk capacity. Risk tolerance means how much risk you’re comfortable taking on. This is entirely a personal choice but generally, investing experts say that the younger you are, the more risk you can tolerate since you’d have longer to recover from a market downturn.
Risk capacity is the amount of risk you need to take to reach your investment goals. Risk capacity may not always align exactly with risk tolerance so it’s important to measure both to determine how wide the gap may be. Between a fixed and variable annuity, the variable annuity would mean taking on more risk.
To keep things in perspective, consider what type of returns you’re looking for on your money. If you have other retirement investments, such as a 401(k), individual retirement account or a pension, then you may not need your money to rack up huge returns. On the other hand, if you’re feeling underprepared for retirement, you may need to see a little more growth from your annuity to reach your income goals.
The Bottom Line
Like any other retirement planning tool, it’s important to look at the potential pros and cons before including an annuity as part of your long-term financial strategy.
Tips on Annuities
- Consider talking to a financial advisor about what an annuity fund is and the advisability of buying an annuity. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Read the fine print on annuity fees carefully, as there are a number of charges you may have to pay. For example, you should be familiar with administrative fees, surrender charges and the expense ratio for each fund you’re invested in.
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