Types of Annuities and How they Work

Posted on August 19th, 2021
annuities how works

The other day I was craving tacos. The hunger was fierce. So, I decided to head to my favorite Mexican restaurant to satisfy my appetite.

Usually, I choose between either coconut shrimp or carnitas. But, on this particular day, I wanted to try something different. But, I quickly became overwhelmed by the possibilities.

Granted, this was a Chiptole situation where I could apparently have some 655,360 combinations to pick from.But, stilll, the decision wasn’t easy. And, while I was standing in line, I got to thinking. This is kinda similar to annuities.

That might seem like a stretch. But, it’s true. If you want to buy a taco, you have several different options based on your preferences and dietary needs. The same is true with annuities. There are different types that are designed to meet your specific retirement needs.

So, let’s explore what the different types of annuities are and how they work so that you can pick the best one.

The Main Types of Annuities

Generally speaking, there are two basic annuity types, immediate and deferred. The main difference between them is your payout options. With an immediate annuity, you’ll receive payments right away. A deferred annuity will have to wait until a future date to collect your money.

Here’s where things can get hairy. Within these basic categories there are three other types of annuities;

  • Fixed. As a result of the contract, you will receive a fixed amount based on an interest rate.
  • Variable. This is a tax-deferred annuity that allows you to invest finances into subaccounts.
  • Indexed. The return is based on the performance of a stock index, such as the S&P 500 Composite Stock Price Index.

Still, confused? No worries. Let’s further explain what these annuity types are and how they operate.

Fixed

The least risky, most predictable, and straightforward annuity option available. With fixed annuities, the rate of interest is guaranteed and doesn’t change once the contract has been signed. For example, with a Due Fixed Annuity, you’ll receive 3% on every dollar deposited.

However, there are some fixed annuities that where the rate will rise and fall. Often, an interest rate reset occurs after a specified period of time.

In short, a mixed annuity performs like a certificate of deposit (CD). Like a CD, a fixed annuity offers principal protection. As such, it’s a low-risk investment. That does come at the expense of higher growth potential. Upon maturity, you can collect your funds at a guaranteed minimum rate.

However, that’s where the similarities end. In most cases, CDs are used for short-term goals, like putting down a down payment on a house. On the other hand, fixed annuities are long-term investments that you’ll wait and use when in retirement.

How does a fixed annuity work?

An insurance or annuity company sells you a fixed annuity. You have the option to pay this in installments or a lump sum payment. In return, you receive a certain interest rate that the company guarantees.

It’s during the accumulation phase where tax-deferred growth takes place. And, how much you’ll get is determined by the following factors;

  • Amount of the premium
  • The current interest rate
  • How old are you and how long do you expect to live
  • Your gender

Or, you could save yourself the trouble and just stick with a fixed annuity that’s transparent from the get-go. Hint: this would be Due and it’s 3% guaranteed interest rate.

Variable

As with a fixed annuity, a variable annuity is a contract between you and an insurance/annuity company. But, it also grows on a tax-deferred basis and provides a guaranteed retirement income stream. And, it can be purchased with either a single payment or a series of multiple payments.

The key difference? With a variable annuity, you choose from a wide range of investment options known as sub-accounts. As a consequence, this will vary the value of your annuity contract.

Unlike a fixed annuity, the value of your contract fluctuates. This is determined by how your investments are fairing. In most cases, your investment options are mutual funds comprised of stocks, bonds, and, and money market instruments. Often, this will be a combination of these investments.

That means that the potential growth is higher with a variable annuity than a fixed annuity. However, you could also lose money with a variable annuity making it a riskier option. You can attach riders, which you’ll you have to pay for, that can help protect you against market losses.

Because variable annuities hold unique benefits that aren’t available in other insurance products or investment options, they’re distinct. Just note that this uniqueness does come with a price in the form of expensive annuity fees.

How does a variable annuity work?

Purchasing a variable annuity does not mean that you’ll be in the dark regarding your available investment options. There are generally three types of mutual funds when you purchase a variable annuity; stock, bond, and money market. Additionally, you may be able to select other investments, such as stable income value mutual funds.

You don’t have to worry about the accumulation period if you choose an immediate variable annuity. This is because you’ll begin receiving payments as early as a year from buying the contract.

Deferred variable annuities do not follow the same rule though. There are two phases if you select this option, a phase of accumulation followed by a phase of payout. In short, this means you’ll get your money sometime down the road.

Indexed

Also known as equity-indexed annuities or fixed-indexed annuities, index annuities combine the best features both of fixed and variable annuities. But, it also stands on its own by offering unique features. This includes providing a minimum guaranteed interest rate in addition to an interest rate that’s linked to a market index.

Annuities are generally based on well-known and broad indexes. Standard & Poor’s index of 500 stocks is the most popular. Some annuity contracts, however, are based on other indexes like the Nasdaq 100, the Russell 2000, and the Euro Stoxx 50.

In addition, some of these indices may represent certain market segments, while others may allow investors to pick multiple indexes. Moreover, you’ll have more risk, but less growth potential than you would with a fixed annuity thanks to the guaranteed interest rate. However, they’re not as risky or as high-yielding as variable annuities.

How does an indexed annuity work?

Owners of indexed annuities are more likely to earn higher returns than owners of other annuity types. It’s clear that indexed annuities only provide a better return than fixed annuities when the markets are performing well. Additionally, they do provide some level of protection against market declines making them less risky than variable annuities.

As with other annuity types, you promised a guaranteed income stream that grows tax-deferred. Also, you can fund an indexed annuity with one lump sum or recurring payments over time. But, you can decide when you want withdrawals to begin.

When you go to buy an indexed annuity contract, you’ll select an index, such as the S&P 500. The annuity company invests this money into that specific index. However, never put all of your eggs into one basket. As such, you should diversify your portfolio by placing your money into various indexes.

How is the rate on an indexed annuity is calculated? You select an index that reflects the change over the previous year. Alternatively, it may be based on a 12-month average gain. Overall, a specific index is used to index annuities.

There is a major concern with indexed annuities though. And, that’s that you may not receive the full benefits of index rises. The reason? There may be limits on potential gains. This is commonly known as the “participation rate.” If the participation rate is 100%, your account will be credited with all of the gains. The percentage may be as low as 25%, however. Usually, indexed annuities offer at least 80% to 90% participation rates.

Annuity Payout Options

In case you forget, annuities can be either immediate or deferred. What separates these two types is when you’ll begin receiving payments..

Immediate Annuity

An immediate annuity pays out payments within a year after it is purchased and is sometimes called an income annuity. An example of this might be winning the lottery or receiving an inheritance. Or, maybe you have a large sum of money stashed away.

Regardless, you purchase an immediate annuity with one payment. From there, you’ll receive guaranteed payments either for life or a specific timeframe. This is better suited for people approaching or already in retirement.

Why would people buy an immediate annuity? Well, it can prevent them from spending this large lump sum of cash. And, it’s also an effective way to supplement other retirement income, such as Social Security.

Deferred Annuity

With a deferred annuity, investors receive future payments. In most cases, this happens when an investor retires. During this time, the investment grows tax-deferred.

Deferred annuities are a better option for younger investors who have the time to let their savings accumulate. The downside? If you do need this money prior to age 59 ½, you’ll get slapped by a 10% IRS penalty fee.

How Long Are Annuities Paid?

Annuities generally provide longevity protection. That means annuities offer lifetime income that the owner can not outlive. But, there are a variety of options you can pick from.

Lifetime Annuities

These are guaranteed income streams during the annuitant’s lifetime. Some lifetime annuities do allow for beneficiaries to continue receiving payments after the annuitant dies. Annuity payments are based on the health and age of the annuitant.

Fixed-Period Annuities

An annuity with a fixed period, which is also called a term-certain annuity, is like winning a lottery prize. You can either take the cash amount now or receive payments that take place over a number of overs. Typically, payments are spread out over a 20- or 30-year period. A perk with this type of annuity is that it doesn’t take into account the age or health of the annuitant.

Are There Any Other Annuity Options?

To complicate matters even more, there are the following annuity options depending on if you have benfiaricies or not.

  • Annuities that pay only for the duration of the annuitant’s life are called life-only annuities. It’s possible to include provisions for your spouse or even a refund.
  • Period certain life annuities continue to pay even if the annuitant dies before the end of the period.
  • In the case of joint and survivorship annuities, the annuitant and a beneficiary both receive payments over their lives.

And, one more thing. Annuities can be either qualified or non-qualified.

A qualified annuity is funded by pre-tax dollars,” states Deanna Ritchie in a previous Due article. “Contributions to a qualified annuity are dependent on your income. Therefore, you must also follow the required minimum distribution rules that are also applied to traditional 401(k)s and IRAs. This means that you must begin taking minimum distributions starting at the age of 70 ½.”

“With non-qualified annuities, you’re using after-tax dollars to fund the annuity,” adds Albert Costill in yet another Due piece. “That means you’ve already paid taxes on the money that you used to purchase it with.”

“Additionally, there are no required minimum distributions,” he says. “So, in a way, this is similar to how a Roth individual retirement account works. Unlike a Roth IRA, however, earnings that are withdrawn from non-qualified annuities are taxable at your regular tax rate.”

“And, the IRS doesn’t impose limitations on how much you can contribute to a non-qualified annuity annually. Just be aware that the insurance company that sold you the annuity may set an annual cap on contributions.”

Which Annuity Should You Buy?

Before committing to any annuity type, reflect on your specific goals and needs. You should also take stock of your risk level. And, you could also ask the following questions;

  • Is your goal long-term growth or a guaranteed income?
  • When are you planning to retire?
  • Do you have any other sources of income?
  • Do you have a plan for potential lifestyle changes and steady income loss?

For example, a fixed annuity might be your best bet if you hope for a reliable, lifetime income with low risk and costs attached. A variable annuity is worth exploring if you’re willing to take the risk of obtaining higher returns.

Additionally, you can add riders to customize the contract to suit your needs, such as long-term care insurance. As an example, leaving your loved ones a legacy. If so, consider adding a rider that permits you to designate beneficiaries.

Ultimately, you want to talk to a trusted finanical professional before buying any type of annuity. They can help you decide on which option is best for you and your financial future.

Albert Costill

Albert Costill

Albert Costill graduated from Rowan University with a History degree. He has been a senior finance writer for Due since 2015. His financial advice has been featured in Money Magazine, Fool, The Street, Forbes, CNBC and MarketWatch. He loves to give personal finance advice to millennials.

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