Different Financial Products

The finance industry speaks in its own language, filled with important terms and concepts. Here are explanations of some of the most important terms.


Annuities Fixed Annuities Indexed Annuities Variable Annuities Mutual Funds Stocks

Annuities

An annuity is a contract between you and an insurance company in which the company promises to make periodic payments to you, starting immediately or at some future time. You buy an annuity either with a single payment or a series of payments called premiums.

Some annuity contracts provide a way to save for retirement. Others can turn your savings into a stream of retirement income. Still others do both. If you use an annuity as a savings vehicle and the insurance company delays your pay-out to the future, you have a deferred annuity. If you use the annuity to create a source of retirement income and your payments start right away, you have an immediate annuity.

The two most common types of annuities are fixed and variable. There is also a hybrid called an indexed annuity, also referred to as an equity-indexed annuity or a fixed-index annuity. Variable annuities are securities and under FINRA’s jurisdiction.

Annuities are often products investors consider when they plan for retirement—so it pays to understand them. They also are often marketed as tax-deferred savings products. Annuities come with a variety of fees and expenses, such as surrender charges, mortality and expense risk charges and administrative fees. Annuities also can have high commissions, reaching seven percent or more.

Go here for additional information on annuities.

Fixed Annuities

An annuity is a contract between you and an insurance company in which the company promises to make periodic payments to you, starting immediately or at some future time. You buy an annuity either with a single payment or a series of payments called premiums.

Some annuity contracts provide a way to save for retirement. Others can turn your savings into a stream of retirement income. Still others do both. If you use an annuity as a savings vehicle and the insurance company delays your pay-out to the future, you have a deferred annuity. If you use the annuity to create a source of retirement income and your payments start right away, you have an immediate annuity.

Annuities come in a few varieties: fixedvariable and indexed. This article explains fixed annuities.

What is a Fixed Annuity?

With a fixed annuity, the insurance company guarantees both the rate of return (the interest rate) and the payout to the investor. Although the word “fixed” might suggest otherwise, the interest rate on a fixed annuity can change over time. The contract will explain whether, how and when this can happen. Often the interest rate is fixed for a number of years and then changes periodically based on current rates.

Payouts can be for an entire lifetime, or you can choose another time period.

While you are accumulating assets in a deferred fixed annuity, your investment grows tax-deferred. The insurance company agrees to pay you no less than a specified rate of interest during the time that your account is growing. With an immediate fixed annuity—or when you “annuitize” your deferred annuity—you receive a pre-determined fixed amount of money, usually on a monthly basis (similar to a pension). These payments may last for a specified period, such as 25 years, or an unspecified period such as your lifetime or the lifetime of you and your spouse.

The predictability of a fixed annuity makes it a popular option for investors who want a guaranteed income stream to supplement their other investment and retirement income. Fixed annuity payouts are not affected by fluctuations in the market, so they can provide peace of mind for investors who want to ensure that they will have enough money to carry them through retirement and cover identified future expenses.

Indexed Annuities

An annuity is a contract between you and an insurance company in which the company promises to make periodic payments to you, starting immediately or at some future time. You buy an annuity either with a single payment or a series of payments called premiums.

Some annuity contracts provide a way to save for retirement. Others can turn your savings into a stream of retirement income. Still others do both. If you use an annuity as a savings vehicle and the insurance company delays your pay-out to the future, you have a deferred annuity. If you use the annuity to create a source of retirement income and your payments start right away, you have an immediate annuity.

Annuities come in a few varieties: fixedvariable and indexed. This article explains indexed annuities.

What is an Indexed Annuity?

Indexed annuities—also known as “equity-indexed annuities” or “fixed-indexed annuities”—are complex financial instruments that have characteristics of both fixed and variable annuities. Indexed annuities offer a minimum guaranteed interest rate combined with an interest rate linked to a market index, hence the name.

Many indexed annuities are based on broad, well-known indices like the S&P 500 Composite Stock Price Index. But some use other indexes, including those that represent other segments of the market. Some indexed annuities allow investors to select one or more indexes. Because of the guaranteed interest rate, indexed annuities give you more risk (but more potential return) than a fixed annuity, but less risk (and less potential return) than a variable annuity.

Annuities come in a few varieties: fixedvariable and indexed. This article explains indexed annuities.

Variable Annuities

An annuity is a contract between you and an insurance company in which the company promises to make periodic payments to you, starting immediately or at some future time. You buy an annuity either with a single payment or a series of payments called premiums.

Some annuity contracts provide a way to save for retirement. Others can turn your savings into a stream of retirement income. Still others do both. If you use an annuity as a savings vehicle and the insurance company delays your pay-out to the future, you have a deferred annuity. If you use the annuity to create a source of retirement income and your payments start right away, you have an immediate annuity.

Annuities come in a few varieties: fixedvariable and indexed. This article explains variable annuities.

What is a Variable Annuity?

As its name implies, a variable annuity’s rate of return changes with the stock, bond and money market funds that you choose as investment options. Variable annuities are sometimes compared to mutual funds because they offer similar investment features, including investment choices—called “separate accounts”—that resemble mutual funds. However, they are different products.

A typical variable annuity offers three basic features not commonly found in mutual funds:
• tax-deferred treatment of earnings;
• a death benefit; and
• annuity payout options that can provide guaranteed income for life.

While a variable annuity has the benefit of tax-deferred growth, its annual expenses are likely to be much higher than the expenses on a typical mutual fund. And, unlike a fixed annuity, variable annuities do not provide any guarantee that you will earn a return on your investment. Instead, there is a risk that you could actually lose money.

In general, variable annuities have two phases: (1) the “accumulation” phase, when the premiums you pay are allocated among investment portfolios, or subaccounts, and your earnings on these investments accumulate; and (2) the “distribution” phase, when the insurance company guarantees a minimum payment to you based on the principle and investment returns (positive or negative).

During the accumulation phase, it can be difficult and costly to access the money you’ve invested. You often have to pay what are called “surrender charges” to withdraw your money early—and you might incur tax liabilities on the earnings your investment has made. In the distribution phase, you typically can choose to withdraw money in a lump sum or as a series of payments over time. Regardless, your distribution will depend on the performance of the investment options you chose.

Annuities come in a few varieties: fixedvariable and indexed. This article explains variable annuities.

Mutual Funds

Mutual funds are a popular way to invest in securities. Because mutual funds can offer built-in diversification and professional management, they offer certain advantages over purchasing individual stocks and bonds. But, like investing in any security, investing in a mutual fund involves certain risks, including the possibility that you may lose money.

Technically known as an “open-end company,” a mutual fund is an investment company that pools money from many investors and invests it based on specific investment goals. The mutual fund raises money by selling its own shares to investors. The money is used to purchase a portfolio of stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments. Each share represents an ownership slice of the fund and gives the investor a proportional right, based on the number of shares he or she owns, to income and capital gains that the fund generates from its investments.

The particular investments a fund makes are determined by its objectives and, in the case of an actively managed fund, by the investment style and skill of the fund’s professional manager or managers. The holdings of the mutual fund are known as its underlying investments, and the performance of those investments, minus fund fees, determine the fund’s investment return.

While there are literally thousands of individual mutual funds, there are only a handful of major fund categories:
• Stock funds invest in stocks
• Bond funds invest in bonds
• Balanced funds invest in a combination of stocks and bonds
• Money market funds invest in very short-term investments and are sometimes described as cash equivalents

You can find all of the details about a mutual fund—including its investment strategy, risk profile, performance history, management, and fees—in a document called the prospectus. You should always read the prospectus before investing in a fund.

Mutual funds are equity investments, as individual stocks are. When you buy shares of a fund you become a part owner of the fund. This is true of bond funds as well as stock funds, which means there is an important distinction between owning an individual bond and owning a fund that owns the bond. When you buy a bond, you are promised a specific rate of interest and return of your principal. That’s not the case with a bond fund, which owns a number of bonds with different rates and maturities. What your equity ownership of the fund provides is the right to a share of what the fund collects in interest, realizes in capital gains, and receives back if it holds a bond to maturity.

How Mutual Funds Work

If you own shares in a mutual fund you share in its profits. For example, when the fund’s underlying stocks or bonds pay income from dividends or interest, the fund pays those profits, after expenses, to its shareholders in payments known as income distributions. Also, when the fund has capital gains from selling investments in its portfolio at a profit, it passes on those after-expense profits to shareholders as capital gains distributions. You generally have the option of receiving these distributions in cash or having them automatically reinvested in the fund to increase the number of shares you own.

Of course, you have to pay taxes on the fund’s income distributions, and usually on its capital gains, if you own the fund in a taxable account. When you invest in a mutual fund you may have short-term capital gains, which are taxed at the same rate as your ordinary income—something you may try to avoid when you sell your individual securities. You may also owe capital gains taxes if the fund sells some investments for more than it paid to buy them, even if the overall return on the fund is down for the year or if you became an investor of the fund after the fund bought those investments in question.

However, if you own the mutual fund in a tax-deferred or tax-free account, such as an individual retirement account, no tax is due on any of these distributions when you receive them. But you will owe tax at your regular rate on all withdrawals from a tax-deferred account.

You may also make money from your fund shares by selling them back to the fund, or redeeming them, if the underlying investments in the fund have increased in value since the time you purchased shares in the funds. In that case, your profit will be the increase in the fund’s per-share value, also known as its net asset value or NAV. Here, too, taxes are due the year you realize gains in a taxable account, but not in a tax-deferred or tax-free account. Capital gains for mutual funds are calculated somewhat differently than gains for individual investments, and the fund will let you know each year your taxable share of the fund’s gains.

Active vs. Passive Management

When a fund is actively managed, it employs a professional portfolio manager, or team of managers, to decide which underlying investments to choose for its portfolio. In fact, one reason you might choose a specific fund is to benefit from the expertise of its professional managers. A successful fund manager has the experience, the knowledge, and the time to seek and track investments—key attributes that you may lack.

The goal of an active fund manager is to beat the market—to get better returns by choosing investments he or she believes to be top-performing selections. While there is a range of ways to measure market performance, each fund is measured against the appropriate market index, or benchmark, based on its stated investment strategy and the types of investments it makes.

For instance, many large-cap stock funds typically use the Standard & Poor’s 500 Index as the benchmark for their performance. A fund that invests in stocks across market capitalizations might use the Dow Jones Wilshire 5000 Total Stock Market Index, which despite its name measures more than 5,000 stocks, including small-, mid-, and large-company stocks. Other indexes that track only stocks issued by companies of a certain size, or that follow stocks in a particular industry, are the benchmarks for mutual funds investing in those segments of the market. Similarly, bond funds measure their performance against a standard, such as the yield from the 10-year Treasury bond, or against a broad bond index that tracks the yields of many bonds.

One of the challenges that portfolio managers face in providing stronger-than-benchmark returns is that their funds’ performance needs to compensate for their operating costs. The returns of actively managed funds are reduced first by the cost of hiring a professional fund manager and second by the cost of buying and selling investments in the fund. Suppose, for example, that the management and administrative fees of an actively managed fund are 1.5 percent of the fund’s total assets and the fund’s benchmark provided a 9 percent return. To beat that benchmark, the portfolio manager would need to assemble a fund portfolio that returned better than 10.5 percent before fees were taken out. Anything less, and the fund’s returns would lag its benchmark.

In any given year, most actively managed funds do not beat the market. In fact, studies show that very few actively managed funds provide stronger-than-benchmark returns over long periods of time, including those with impressive short term performance records. That’s why many individuals invest in funds that don’t try to beat the market at all. These are passively managed funds, otherwise known as index funds.

Passive funds seek to replicate the performance of their benchmarks instead of outperforming them. For instance, the manager of an index fund that tracks the performance of the S&P 500 typically buys a portfolio that includes all of the stocks in that index in the same proportions as they are represented in the index. If the S&P 500 were to drop a company from the list, the fund would sell it, and if the S&P 500 were to add a company, the fund would buy it. Because index funds don’t need to retain active professional managers, and because their holdings aren’t as frequently traded, they normally have lower operating costs than actively managed funds. However, the fees vary from index fund to index fund, which means the return on these funds varies as well.

Some index funds, which go by names such as enhanced index funds, are hybrids. Their managers pick and choose among the investments tracked by the benchmark index in order to provide a superior return. In bad years, this hybrid approach may produce positive returns, or returns that are slightly better than the overall index. Of course, it’s always possible that this type of hybrid fund will not do as well as the overall index. In addition, the fees for these enhanced funds may be higher than the average for index funds.

Go here for additional information on mutual funds.

Stocks

When you invest in a stock, you become one of the owners of a corporation. Stocks represent ownership shares, also known as equity shares. Whether you make or lose money on a stock depends on the success or failure of the company, which type of stock you own, and what’s going on in the stock market overall and other factors.

Go here for additional information on stocks

 
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