A lot of us have heard of annuities either on TV, radio or maybe in the Wall Street Journal. Some of you may even have an annuity in your investment portfolio, but for the majority of us annuities seem complicated and downright confusing so we avoid them, but when it all boils down to it annuities aren’t nearly as complicated as many assume.

In simplest terms, annuities are an investment between you and an insurance company where you pay them a set amount of money and they pay you back over time the amount you invested plus a rate of return on top of your investment. You can make your payments either all at once (as is the case with many structured settlements or lottery winners) or you can make them over time in monthly, quarterly or annual installments.

The amount of interest that the annuity provider pays you depends on the type of annuity you buy. There are two main types of annuities, fixed and variable. Fixed annuities are the easiest to understand, they provide a fixed rate of return which is guaranteed for a set amount of time or for the life of the annuity. For example, you may invest in a $50,000 fixed rate annuity that pays 4% annually. In this case the 4% would be your fixed annuity rate, and you would receive payments based on your investment plus this 4% interest.

The downside to fixed annuities is that they offer very limited upside potential, so that’s why many annuity providers are now offering variable annuity options. Variable annuities offer many of the same benefits that fixed annuities do, but differ in one primary way. Instead of offering a fixed rate of return, your return is instead based on a combination of other investment vehicles like a series of stocks, bonds, mutual funds or money market accounts that you choose to invest in. With variable annuities your payouts will vary depending on how your investment choices perform. Obviously this adds an additional element of risk to your investment, but some companies will cap the annuity downside by providing a minimum rate of return which is often lower than that offered with a fixed annuity.

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