An annuity is a special type of comparatively low-risk investment where money is invested in exchange for a defined series of future pay backs. When we discus annuities it is important to distinguish between the different forms of annuity since several legal constructions are referred to as annuities even though their purpose and content vary significantly. The word “annuity” comes from “annus”, the Latin word for year. The first forms of annuities were always paid out once a year, hence the name. Today, the annuitant – the individual that receives money from an annuity – can choose to purchase an annuity where the money is paid out more frequently, such as once a month.
There are two basic types of annuity: immediate annuity and deferred annuity. Immediate annuity is the oldest form of annuity and this type of legal contract has existed for at least 400 years. An annuity is chiefly a way of distributing already existing assets over time. The immediate annuity was one of the first forms of pensions, since an individual could trade a lump sum of money in exchange for regular payments over a pre-specified period, e.g. 10 years or from the time of retirement until the death of the annuitant.
The deferred annuity on the other hand, is not chiefly a way of investing already existing means but a way of gradually accumulating money that will be paid out later. A deferred annuity is therefore typically purchased rather early in life when the future annuitant is still middle age. An immediate annuity on the other can be purchased the same day as the annuitant retires, e.g. by friends and co-workers that wish to provide the annuitant with a pension. An immediate annuity can naturally be purchased decades in advance as well, and immediate annuities and deferred annuities can be set up for other purposes than providing someone with a pension. The deferred annuity was invented during the 1970s and is today one of the most popular ways of saving money for old age in the United States since the seller – an insurance company – offers a safer investment rate than standard investments. Deferred annuities are often linked to index funds or other stock funds in order to provide a stable interest rate on the deferred annuity. The accumulated values are not taxed until money is paid out from the deferred annuity (tax-deferred growth).
When you purchase a deferred annuity you will typically choose between three different forms of deferred annuities: Fixed Deferred Annuity, Variable Deferred Annuity and Equity Indexed Deferred Annuity. If you want a deferred annuity that grows due to interest rate earnings alone, you should choose a Fixed Annuity. If you want a more risky investment where the potential growth rate is higher you can instead choose a Variable Annuity. The value of a Variable Annuity can sink below the initial purchase value since the money will be allocated in stock and/or bond funds and not be guaranteed by the insurance company. The Equity Indexed Annuity (EIA) is a comparatively new form of deferred annuity and can be described as a mix between the two older forms of deferred annuity. The insurance company will guarantee that the value of the deferred annuity never sinks below the initial purchase value and the deferred annuity will be linked to the growth of some major stock market index, e.g. the Dow Jones Industrial Average.