At its core, an annuity is a cross between a certificate of deposit (CD) and an insurance product, most commonly used as a financial-planning tool for retirement or a low-risk hedge against market downturns. The purchaser puts down a lump sum deposit which grows either through a guaranteed rate of interest or based on the performance of an underlying investment vehicle/stock index. Meanwhile, the seller sends you monthly or annual payments which eventually add up to the actual or projected value of your account (depending on the type of annuity you purchase).
With fixed annuities, you deposit a large amount of cash upfront in exchange for a guaranteed rate of interest over a set time frame, usually between 3 percent and 10 percent. To calculate the size of each payment, the seller takes your net deposit size (your initial deposit minus a commission fee) and determines its mature value (the initial value plus the interest accrued during the terms of the contract). However, annuities also include annual management fees and insurance fees. Therefore, the seller multiples the final value of your account by the annual management fee and insurance fee percentages, which he then subtracts from the mature value. Finally, the difference is divided by the total number of scheduled payments to arrive at the take-home value of each individual payment.
While slightly more aggressive than fixed rate contracts, index annuities also require you to make a large, up-front cash deposit. Index annuities grow in two ways: a small, guaranteed interest rate (typically 1 percent to 3 percent) and growth tied to investments in stock indexes. After subtracting commission from your deposit, the seller determines the minimum possible size of your account's mature value. He then subtracts annual management and insurance fees to determine the final net value. By dividing this figure by the total number of scheduled payments, he arrives at your minimum, guaranteed payment size per year.
However, the actual annual payment you receive is equal to the minimum guaranteed size plus a percentage (set forth in the terms of the contract) of any increase in value to your account (which is invested in an stock-index mutual fund) over the past year.
Deferred Variable Annuities
Variable annuities carry the highest relative amount of risk but also provide the most flexibility and highest potential returns. In these products, you have the option of investing your money in several different vehicles, from low-risk money market funds to high-risk, high-return exotic products. However, the downside is that there is no "safety net" or guaranteed interest rates.
Purchased either with a lump sum payment or through a stream of small contributions, variable annuities come in two classes: deferred and immediate. A deferred variable annuity is like a 401(k) or Roth IRA in that it allows you to invest your money without paying annual capital gains taxes every time you change positions. And, unlike a 401(k) or Roth IRA, deferred variable annuities have no maximum annual contribution limit.
When the annuity finally reaches maturity, fees are subtracted from the total value of your account and the difference is divided by the total number of payments you chose (monthly, quarterly, annually). This figure is your payment size.
Immediate Variable Annuities
For immediate variable annuities, monthly payment size is determined at the start of each year, depending on the market value of your investments. In this sense, an immediate variable annuity is like a fixed annuity that your renegotiate every year. For example, to determine the monthly payments for the first year, divide your net account size (market value of investments minus annual management fees) by the total number of payments you will receive throughout the entire, multi-year term of the contract. The figure you arrive at will be the guaranteed amount you receive for every payment that year. If the market value of your account increases over the course of the year, you can lock-in a higher monthly payment size for the next year. However, if the market value of your account declines, you will get locked-in to a lower monthly payment size for the next year.