Annuities: Types & Benefits

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  • 0:02 Definition of an Annuity
  • 0:53 The Types of Annuities
  • 1:39 Investment Options and…
  • 3:32 Disadvantages to Annuities
  • 4:43 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define annuity and learn about the two main types of annuities. We'll also discuss three annuity investment options, including the benefits and disadvantages of each.

Definition of an Annuity

Emmitt has worked in the manufacturing industry for 25 years. He's approaching retirement and meeting with a financial consultant to discuss a retirement strategy. Matt, a financial guru, asks Emmitt several questions and finds out he's maxed out matching retirement benefits from his employer and is interested in opening another retirement account.

Matt suggests Emmitt open an annuity, which is an investment product that pays a periodic income stream. He tells him to look at it this way: An investor deposits a specific amount of money or makes monthly payments before they retire in return for monthly or quarterly payments with interest after retirement.

There are two main types of annuities: immediate and deferred. With each type, there are three main investment options: fixed, variable, and equity-indexed. Let's take a closer look.

The Types of Annuities

Emmitt tells Matt that he will retire in five years and is, therefore, not interested in an immediate annuity. An immediate annuity requires a lump-sum initial investment after which payments start immediately. This type of annuity is for a person who's ready to retire now.

However, since Emmitt will retire in five years, Matt suggests he open a deferred annuity. With this type, Emmitt can make monthly payments over the next five years and then begin receiving payments after he retires.

Regardless of the type of annuity, an insurance company invests the client's lump sum or payments, then pays them periodic payments over a set period of time, or a fixed-period annuity, or until they die, or a lifetime annuity.

Investment Options and Benefits

After they agree on which type of annuity to open, Matt tells Emmitt there are three types of investment options he can choose from. However, he needs to assess Emmitt's risk tolerance to determine the best option. Risk is the possibility of a financial loss. Some investors prefer to invest in safe products where they will lose very little money. Keep in mind there's a direct correlation between risk and return. Return is the interest rate you receive from investing. So, when there is little risk, there is a low return. Investors who choose this method are known as conservative. Conservative investors prefer fixed-rate investments where the interest rate is set and does not change.

Aggressive investors, on the other hand, prefer to gamble and invest in risky investments with the understanding that increased risk can bring a high return. These investors are willing to accept a variable rate. A variable rate is where the interest rate fluctuates. Aggressive investors are hoping for a substantial increase in return rates above their original investment.

Lastly, there are those investors who are willing to take some risk in hopes of a decent return. These investors are not risk takers or aggressive, nor are they risk intolerant or conservative; they are in between and considered moderate investors. Moderate investors are interested in equity-indexed annuities, which guarantee a minimum return with a chance of increased returns if the market rises.

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