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One of my favorite questions:  What exactly is an annuity? Let me break it down to its basic function. An annuity is an investment contract with an insurance company, much like a CD is an investment contract with a bank.

Now, there are major differences. Your bank CD is probably going to be what is called FDIC insured, and your annuity is probably not going to be FDIC insured. Those are completely different things there. Having the FDIC and not having the FDIC. It’s an investment contract.

Now there are four main types of annuities. The first is a fixed annuity. The second is a variable annuity. The third is a fixed indexed annuity. And the fourth, which many people wouldn’t actually consider a different type of annuity but I do, is called an immediate annuity.

The fixed annuity is really simple. It’s where you’ve given your money to the insurance company and the insurance company guarantees you a certain interest rate on that money for a certain period of years. Could be one year, could be five years, could be ten years, something like that.

So you take them $100,000, they say, for this $100,000 we’ll guarantee you a 5% interest rate for the next five years. You say, “great”, shake hands, boom, you do the deal. Now you’ve got that. Now one of the key differences between let’s say a CD and an annuity is the growth you get inside of your annuity gets to grow tax deferred. Now if that annuity is also inside of a Roth IRA, it’s going to grow tax deferred and because the IRS looks at the Roth IRA first, it’s going to come out tax-free.

Now a variable annuity is a little bit different. You take that insurance company $100,000 and you go, here, but I’d like you to take that $100,000 and I’d like you to put part of it in Fidelity, part of it in Janus, part of it in Alger, part of it in Vanguard. And they go, no problem. And now the returns you get are based on those, what we call subaccounts. And you go, “well Pete, I’ve never heard this term subaccount before. I mean, this looks like the Fidelity account. It looks like a mutual fund.” Well, it does look like a mutual fund. It smells like a mutual fund. It might even have the same fund manager as the mutual fund. But when it’s in insurance, it’s no longer called mutual fund. It’s called a subaccount. So what’s the difference? I don’t know, a few letters in the name? Basically, that’s the main difference.

So you get to go up when the market goes up and down when the market goes down. However, on a variable annuity, if you put $100,000 in it and let’s say the market fell to $80,000 and you died, your heirs would get the full $100,000 because it’s inside of this annuity, and an annuity is an insurance contract so the insurance company has to give you something for that, and basically what they’re giving you is a death benefit, that no matter what happens you’re at least going to get how much money you put in, minus however much money you’ve personally taken out. So if the market falls, hey, it falls. But you died, great, your heirs get all of it. If you say, hey, I put in $100,000, it grew to $110,000 but I took out $30,000, well then your heirs are going to get $80,000. Because it went up to $110,000, you pulled out $30,000. Does that make sense?

Now, the third is the fixed indexed annuity. These have been really, really popular and there are some great indexed annuities out there and there are some really, really bad indexed annuities out there that I wouldn’t touch with a ten-foot pole. Now, the same can be said with almost any investment, so you can’t just look at it and say, well, this investment’s good or this investment’s bad. There’s a time and a place for everything. But let me give you the basics of how an indexed annuity works. I’m going to make it really simple because I’m only going to talk about one of the options in an indexed annuity.

We’re going to say that this indexed annuity, your growth that you get is based on the S&P 500. So what this means is this. They’re going to give you a cap as to how much growth you can get, and you’re going to have a floor as to how little growth you can get. So let’s say our cap is 10%, and the S&P goes up 7%. Well, you put $100,000 in, a year later they look at it and they go, okay, the S&P 500’s up 7%, your cap is at 10%, we’re going to give you 7% on that money. The next year after that it goes up another 15%. Well, your cap is at 10%, so you only get 10%. Let’s say it’s three great boom years in a row, the next year it goes up 35%. All you’re going to get is 10%. That’s the cap. That’s the best you can do. Now let’s say the following year after that we have the great crash of 2008 all over again, right? And the market goes down 40%. You get zero. You see, your money’s not actually in the S&P 500, it’s linked to it. So if the market goes down, you don’t lose anything because it’s not actually in it. It just means that year you didn’t make any interest.

Now when you start to understand that concept, these start to look really, really nice because you get to go up. Granted, you don’t get to go up all the way with the market, but you’re guaranteed that you’re never going to lose. Now, as long as you can deal with just getting moderate gains, this may not be a bad option for a lot of people.

It’s not really meant to compete with the securities markets, it’s meant to compete with the fixed markets, like the fixed annuities, the CDs, things like that. That’s what it’s really meant to be. So it’s somewhere in between the fixed markets and the stock market as far as what you can potentially get as far as gain is concerned.

Now, the fourth option is the immediate annuity. And the immediate annuity is very much like a pension. You give the insurance company let’s say $100,000 and they guarantee you that you’re going to get an income for the rest of your life. It’s going to come to you if you want it every month or every quarter or every year, it doesn’t really matter to most immediate annuity companies. And so that’s why I kind of look at it a little bit differently because the other three are all meant for growing your money, and the immediate annuity is meant for income, and that’s exactly what it’s going to provide to you is income.

Now having said all this, there are a lot of variations on annuities, and like I said before, some of them are great, some of them are really bad. Before you go putting yourself into an annuity, you need to talk to a qualified professional who understands this stuff and isn’t just limited to these types of products. If you go talk to a car salesman, he’s going to sell you a car. But what if what you really needed was a truck or a motorcycle? Well, if he doesn’t have those, he’s not going to offer that to you. So you want to make sure that you’re talking with someone who’s not just pigeonholed, which are usually just—and I don’t mean to offend anybody—basic insurance agents. Of course they’re going to tell you, hey, you need this.

They’re great options, but you just need to make sure that you’re getting a look at all of your options.

I’m Pete Mitchell, and I look forward to sharing more on the markets and investing with you later.