How do annuities work?
The term “annuity” basically refers to an agreement that is made between two parties. One of these parties is usually an individual, who delivers a sum of money, called a premium, in periodic payments or a lump sum, to the second party, which is usually an insurance company. In return, the second party delivers a steady stream of payment to the first party for a specified period of time that is set out in the agreement.
Annuities are long-term products and are a very easy approach to financing your future. However, before you buy, it is important that you have a good understanding of what you are buying.
There are two main types of annuity agreements. The first, called certain annuity, specifies the term determined for the payment. For example, suppose you pay a certain amount of money to an insurance company for a twenty-year annuity. You make an agreement whereby monthly payments are sent along with a percentage of growth, over the term of the annuity. You will be paid a specific amount of money, each month, until the agreement ends.
The second type, called an annuity, is most commonly used by people with retirement savings in mind. In this settlement, you pay a lump sum to the insurance company and they pay you back in a specified amount each year for the rest of your life. Annuities, when conducted in conjunction with a charity or non-profit organization, may offer additional tax benefits.
Among the many things to know about investing in an annuity is that you primarily have two types of balances that run concurrently. The first balance is your account value, also known as the contract value. This refers to the amount of money available to you at any given time. It largely depends on the performance of the investments within the annuity which are also known as subaccounts.
The second is the benefit base or income base which is considered more like a hypothetical account. It is used to represent the amount of money that determines the guaranteed annual income that can be taken out of the annuity.
It’s important to be aware of the differences between these two, as you’ll sometimes find variable annuities surrounding a guaranteed return that apply only to your income base and not your actual account value. The value of earnings is not the amount you can withdraw. The only balance you can withdraw when you need to is your account value, which may or may not be greater than your income base.
From time to time, the insurance company will compare the value of your account with the income base. This, in most cases, is done on the anniversary date of the contract. If the value of your account turns out to be more than your income base, then the insurance company will increase the benefit base to equal the value of the account.