Annuities may seem complex. In reality, they’re very straightforward — like a warm and delicious pizza. All variations of pizza contain the following basic structure; crust, sauce, cheese, and toppings. As for annuities, it’s nothing more than a contract between you and an insurance company. In exchange for premium payments, you’ll receive payments at a future date. Usually, this is either on a monthly, quarterly, semi-annual, or annual basis or in lump-sum.
But, just like when ordering a pizza, there are different types of annuities. Do you want New York or Chicago style? Are you more of a Sicilian or Neopolitan fan? Your answers will depend on your palette or even geographical location.
Depending on your short-and-long-term goals, as well risk tolerance, the type of annuity you end-up buying will vary. How can you make this decision easier? Well, let’s discuss what the five most common types of annuities are so you can pick the right type.
Immediate vs. Deferred Annuities
In general, there are two main types of annuities; immediate and deferred.
With an immediate annuity, you’ll start receiving income, well, immediately. In contrast, deferred annuities provide you with a regular income payment later in life. In most cases, when you retire. As long as you can wait to receive payments, a deferred annuity should more than suffice — plus you’ll avoid potential early withdrawal penalties.
What are immediate annuities?
With an annuity contract, you can start receiving payments immediately. As a result, it’s more advantageous for retirees who are in need of a guaranteed income stream. This can help with living expenses and health care costs when you retire.
In addition to being called a single premium immediate annuity (SPIA), this type of annuity guarantees a fixed retirement income. Generally, you’ll receive regular payments from an insurance company, broker, or financial advisor once you pay a lump sum, aka a premium. As such, this makes the least complicated annuity available.
In contrast to deferred annuities, payments can take place within as little as a month. Payments can also be scheduled on an as-needed basis. The payment method is known as the “mode,” and it can be monthly, quarterly, or yearly.
It’s not uncommon for retirees to supplement their retirement income with immediate payment annuities. An immediate annuity can be used to provide income both for life and for a set time period, e.g., 5 or 10 years.
Payment amounts are based on factors like age, prevailing interest rates, and the length of time you want to continue making payments. An immediate annuity usually has a fixed interest rate for the contract period, but not for the rest of the contract. A few insurers, however, offer immediate variable annuities. With this type, the performance of an underlying portfolio of securities fluctuates similarly to variable deferred annuities. Moreover, there’s also the inflation-indexed annuity, which adjusts payments in conjunction with future inflation.
In addition to its simplicity, immediate annuities have several appealing perks. Most notably, bypassing the accumulation phase, portfolio stability, and no sales or administrative costs.
But, there are drawbacks to be aware of as well. These include higher upfront costs and inflation can cause it to lose value.
What are deferred annuities?
You can think of a deferred annuity as a long-term investment. An annuity provider will then invest a sum of money for you based on the type and strategy you choose. Payments are made once the initial amount has accrued interest.
Unlike an immediate annuity, deferred annuities have two distinct components;
- When you purchase the annuity, you begin the accumulation phase. This phase ends when your last payment is received. Meanwhile, interest is accumulating tax-deferred. Depending on the annuity type you chose, how accumulation occurs will vary.
- When you are paid for the first time, the payout phase kicks off. Payments can either be made in a lump sum or spread over a period of time. In order to receive a series of payments, you must specify a specific period of time or how long you will receive the payments.
The following scenario is probably familiar to anyone who has purchased a certificate of deposit (CD). There are also parallels between deferred annuities and retirement accounts such as 401(k)s and IRAs. The more time you leave a sum of money alone, the more it will increase. The result will be larger payments sometime in the future.
In addition, the money grows tax-free. Thus, when you begin receiving payments, you will have to pay taxes on ordinary income.
The IRS will impose a 10% penalty fee on you, however, if you make a withdrawal before you are 59 ½ years of age.
Besides tax-deferred growth, compound interest, and unlimited gains, you might consider this type because there are guarantees against the loss of principal. But, some avoid deferred annuities because they can be complex, expensive, and illiquid.
Annuity Interest Types
An annuity’s payment schedule can be subject to immediate or deferred payment schedules. But annuities can also be distinguished by their way of earning interest. Interest accumulates differently among fixed, variable, and fixed indexed annuities. While all three types can be set up with guaranteed income streams, they typically offer withdrawals, systematic withdrawals, and/or systematic withdrawals.
What are fixed annuities?
Just like your standard cheese pizza, fixed annuities are the easiest type to grasp. By agreeing to a guarantee period, the insurance company provides you with a guaranteed interest rate. Depending on your guarantee period, the interest rate could last from a year up to the full duration.
What happens if/when your annuity contract expires? You actually have several options. You can choose to convert your money into an annuity or transfer it into another annuity contract, such as another fixed annuity with a more favorable interest rate.
In this type, the main benefit is that it guarantees steady, tax-deferred earnings. Also, the rates are often higher than those offered by savings accounts and CDs, which typically offer lower returns.
The downside, however, is that growth may not be as robust as with fixed-index or variable annuities. And, there’s that pesky surrender charge or IRS penalty if you made an early withdrawal.
What are variable annuities?
Do you want to grow your annuity funds more than a fixed annuity? Are you comfortable with market fluctuations? If yes to both, then variable annuities might be your type of pizza pie.
With variable annuities, you can allocate your money between several types of investment options called sub-accounts. Eventually, you might be able to convert the variable annuity into a stream of guaranteed payments for the rest of your life by investing the earnings. Also, your earnings with this type are tax-deferred, just like in fixed annuities.
Variable annuities can offer greater earnings appreciation since they are linked to portfolios or investment options. If the sub-account options of the annuity perform well, you might receive a higher payout due to that market exposure. On the flip side, the contributed balance is also at risk.
Variable annuities can also be structured in a way that can result in systematic withdrawals, just like other types of annuities. The contract does come with fees, such as;
- Mortality and expenses
- Administrative fees
- Sub-account fees
- Annual service charges
What’s more, if the contract is terminated during the surrender charge period, you’ll have to pay surrender fees. And, our good friend the early-withdrawal penalty may also be applied.
While variable annuities can provide the greatest growth potential, there’s potential for substantial losses. And, due to the high structure fees, this type of annuity can get pricey.
What are fixed indexed annuities?
As with most annuities, a fixed index annuity is a product that will guarantee income for the rest of your life. So what makes it so distinctive? The fixed deferred interest rate annuity also has some features that are common to tax-favored accumulation products.
There is, however, an index annuity component as well. Rather than using an interest rate to benchmark growth, a stock market index such as the Nasdaq, NYSE, or S&P500 is used instead. Due to the rate floor and cap when it comes to index annuities, their growth never exceeds or falls below the specified returns. Despite fluctuations in the underlying stock indices, this is still true.
Furthermore, the insurance company assumes all risks related to the stock market. As such you won’t lose any of your principal, even if there is a sharp decline. A cap of 3% to 9% may also be available on your potential gains.
In addition to that, premium bonuses are common for fixed index annuities. Unfortunately, this usually means lower potential returns.
Overall, fixed indexed annuities offer principal protection. There’s also potential for significant gains. But, there’s still some market risk and there is a cap on potential earnings. Additionally, guaranteed minimum rates of return may be lower than fixed annuity rates in some cases.
Which Type of Annuity is Right for You?
The short answer to that question? It depends.
As a rule, annuities are regularly promoted as solutions to specific problems. This can include reducing social security taxes, staying in a lower tax bracket, or decreasing Medicare Part B premiums. And, despite being marketed to older individuals, younger people may find that annuities can help them prepare for retirement earlier than later.
But, ultimately when choosing the right type, it comes down to the following factors;
The number of years until retirement.
A deferred annuity may be your best choice if you don’t need current income and want to accumulate wealth in a tax-deferred way. And, just like any pizza, deferred annuities come in various shapes and sizes. In this case, deferred annuities: fixed, fixed-deferred, and variable.
Overall, in contrast with an immediate annuity, a deferred annuity allows you to build substantial funds before retiring. But, it’s also important to consider your level of risk tolerance when selecting a specific type of deferred annuity.
Tolerance for risk.
You should consider what level of wealth you have and how close you are to retirement when determining your risk tolerance for annuities. For instance, approaching retirement reduces your risk tolerance compared to those who are in their 20s or have sufficient retirement savings. It may be best to invest in a fixed annuity if you are in this situation.
In contrast, if retirement is a long way off, you probably have a higher risk tolerance. Why? Because you’ll have more time to recoup losses. With that in mind, you might be better off leaving your money alone and letting earn what it can.
You also may not want to risk your assets if you have a moderate level of assets. But fixed-indexed or variable annuities might be a better option if you’re a more adventurous investor or have the funds to absorb any market losses.
Whether you choose a fixed or variable annuity, it’s important to know what your risk tolerance is and to identify your retirement goals before committing to a contract.
Your unique goals in retirement are arguably the most important factor in selecting an annuity.
As an example, a fixed immediate annuity may best suit someone who enjoys spending time at home but wants a guaranteed retirement income. But, those who own a lot of assets and enjoy travel may prefer to delay payouts and let their money earn interest instead. Are you in this situation? If yes, you may be a good candidate for a variable deferred annuity.
In short. It should provide a sense of relief that there are different types of annuities that cater to your particular retirement goals.