Does an Annuity Have a Fixed Interest?
Insurance companies sell various types of annuities, but generally the annuities fall into two broad categories: immediate annuities and deferred annuities. Immediate annuities involve converting a lump sum into pension style payments. Deferred annuities involve investing a lump sum for a period of years during an accumulation phase before creating an income stream. Fixed annuities are one type of deferred annuity that uses a fixed interest rate during the accumulation phase.
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Fixed Annuity Basics
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Most insurance companies offer fixed annuity contracts that involve the insurer agreeing to pay the annuitant a specific rate of interest for a certain number of years. Most fixed annuity terms last for between four and 10 years. Some companies only guarantee a fixed rate for the first year of the contract after which the rate changes on an annual basis. Fixed annuities with rates that reset annually have a minimum rate guarantee and if the interest rate paid ever falls below the level of the guarantee, the contract owner cancel the contract without a penalty.
Variable Annuity Riders
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Funds invested in variable annuity contracts are actually used to buy mutual funds which have fluctuating values. However, most variable annuity contracts include special features that protect contract owners in the event of market downturns. The account value of a variable annuity at the end of the accumulation phase determines the size of the monthly income payments. The Guaranteed Minimum Income Benefit rider increases the value used to determine future income payments by a fixed percentage each year if the market performs poorly. This increase only effects the hypothetical value used to create an income stream and does not increase the actual cash value of a contract in the event that the contract owner decides to cash in the annuity.
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Indexed Annuity Fixed Rate Guarantees
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Indexed annuities are another kind of deferred annuity on which returns are tied to the performance of an index, such as the Dow Jones Industrial Average. However, indexed annuity contracts also feature fixed rate guarantees. If the DJIA or other index used in the contract performs poorly, the annuitant receives a return based on a fixed interest rate. Indexed annuities usually offer only a very minimal fixed rate guarantee and the contract holders may still get back less than they invested due to charges and fees.
Immediate Annuities
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At the start of an immediate annuity contract, the insurance company multiplies the initial lump sum premium by a certain interest rate and then divides the resultant sum into equal monthly payments that last either for the annuitants life or for a set number of years. However, some contracts have a feature that increases the monthly payments by a fixed percentage rate each year. This feature intends to keep monthly payments in line with inflation, but it does lead to reduced payments in the early years of the contract.
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