When you buy an annuity contract you enter into an agreement with an insurance company that involves you giving the insurer a sum of money and the insurance company agreeing to provide you with income benefits. With an immediate annuity, the insurer converts your premium into a lifetime income stream at the outset of the contract so you have no opportunity to control the investment of your premium. However, on some deferred annuity contracts you can control the investment of your funds and you may have the option to invest your purchase premium in the stock market.
When you buy a deferred annuity, you usually have to wait for at least four years before you start to receive income benefits. In the interim, known as the accumulation phase, the insurance company invests your money so your premium grows before you start to receive income benefits. With a fixed deferred annuity, the insurance company invests your money in an interest-paying account so you have no exposure to stocks. With a variable annuity, you can choose to invest your money in a fixed-interest account or in a mutual fund containing stocks. If you buy an indexed annuity, the insurer invests your money in a fund that contains stocks from a particular index. Therefore, you cannot buy individual stocks, but you can buy stock funds with your annuity premiums.
Variable and indexed annuity contracts typically have longer accumulation phases than fixed annuities. In many cases, the accumulation phase lasts for 10 years or more. Historically, over long periods of time, stocks have outperformed bonds and fixed instruments. Therefore, variable and indexed annuities provide you with the opportunity to grow your money at a faster rate than you could in a fixed-interest account. Stock funds contain many different types of stocks, so this diversity protects you in the event of market downturns. Annuities, like retirement accounts, also provide you with tax-deferred growth.
If you die during the accumulation phase of an annuity contract, your account beneficiary receives a death benefit that equals the higher of your initial premium or the current market value of your investment. This means your beneficiaries are protected against losses stemming from market downturns. Furthermore, many annuity contracts include income guarantees that assure you of a minimal level of return, regardless of market performance, as long as you convert your annuity into a lifetime income stream. Therefore, annuities enable you to invest in stocks without having to endure all of the normal risks that stock investors have to contend with.
While annuities offer you many benefits, you can only invest in the stock funds that your insurance company includes in the annuity prospectus and in many instances you have a choice of just four or five funds. Diversity protects you in market downturns, but it also limits your ability to grow your money because you cannot invest in individual stocks with high-growth potential. Additionally, you can sell stocks outside an annuity at any time but if you cash in your annuity during the accumulation phase, you incur penalty fees that often exceed 8 percent of your principal balance.
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