What are the Different Types of Annuities?
When deciding to purchase an annuity, it is important to understand the various options that you can choose from to ensure the type of annuity is the best one for you.
Different annuity options can be organized into two categories. In other words, you have two choices to make in regard to your annuity.
These choices are:
– When do you want to start receiving payments; and
– What rate of return do you want to receive on your principal.
First Choice: Timing of Payments (Immediate vs. Deferred)
When you purchase an immediate annuity, you make a lump-sum payment to the insurer upfront and receive regular guaranteed payments in return. As the name suggests, you start to receive these payments immediately when you make the initial annuity investment. Immediate annuities allow the annuitant to decide how frequently he or she wants to receive payments, whether monthly, quarterly or yearly. There are a few options to choose from when structuring an immediate annuity. The options include:
Immediate annuities have their share of advantages. The most obvious is the benefit of receiving your payments immediately once you choose to make the investment in the annuity. Additionally, these annuities are highly flexible and can be used to satisfy whatever preferences you may have, as long as you are willing to pay extra for such benefits. Immediate annuities are also relatively easy to understand; they have a simple structure that the investor can easily comprehend.
However, immediate annuities require you to irrevocably invest your initial principal and you would not have access to this money in the event of an emergency. Immediate annuities also make lower payouts than some other types of annuities because the principal investment does not have time to grow in the annuity before the payouts begin.
Immediate annuities are a good option for investors who need immediate income from the investment. Someone who is nearing retirement age and soon will be in need of income may benefit from an immediate annuity. Additionally, the special options that can be added to an immediate annuity may be beneficial depending on the preferences held by the annuitant. These special options include the ones listed above, such as making it a joint annuity, adding a cash refund feature, etc.
Deferred annuities require the annuitant to make an upfront payment to the insurance company, with the guarantee that he or she will receive payments in return once the annuitant reaches an age that is specified in the contract. The payments can be made for a chosen length of time or for the remainder of your life. Like Immediate Annuities, deferred annuities allow the annuitant to decide how frequently he or she wants to receive payments, whether monthly, quarterly or yearly. Also similar to immediate annuities, deferred annuities offer flexible payout options such as a joint annuity, cash refund and guaranteed payments to the beneficiaries for a specified length of time.
While a deferred annuity has the disadvantage of requiring the annuitant to wait to receive payments, it also has many benefits. Deferred annuities are cheaper to buy upfront than immediate annuities, and they enable the annuitant to choose the specific date at which it will be ideal to start receiving payouts. Most importantly, deferred annuities allow the money in the account to grow during the period of time that the payments are being delayed. The money in the annuity will accumulate earnings in a tax-deferred manner, and the original investment may grow substantially over time, which will result in larger payouts to the annuitant when the distributions begin. Giving the original principal the opportunity to grow in the accumulation period means that deferred annuities offer significantly higher payouts than an immediate annuity for the same upfront cash investment
Deferred annuities can be useful in a myriad of situations. Deferred annuities appeal to those who want the security of having guaranteed income in the future, and are not in need of a steady stream of income right now. Deferred annuities are best for people who are planning ahead and wish to have peace of mind about reliable income in the future. Deferred annuities also can be a good fit for people who have limited resources at the time of the purchase, since a lower payment is allowed upfront. Someone who has limited resources and wishes to guarantee themselves income in the future can purchase an annuity and let the principal grow over time to receive more substantial payments down the road.
Second Choice: Desired Rate of Return (Fixed vs. Variable vs. Indexed)
In a fixed annuity, the insurer guarantees the safety of the principal. The insurer also invests the deposits and credits the annuity owner’s account interest at a fixed rate for a specific period of time. In most fixed annuities, the insurer resets the interest rate before the start of each year and guarantees that interest rate will be earned by the annuity during the year. Fixed annuities can be purchased using either a lump-sum payment or a series of payments.
After a period of years, the annuity owner can choose to begin withdrawing money from the annuity. The balance that remains in the annuity will continue to be invested and earn the guaranteed interest rate each year. The annuitant also can choose to have fixed, guaranteed payments made over time just as with an immediate annuity.
Fixed annuities offer the advantage of receiving predictable returns on your investment. Additionally, fixed annuities offer relative safety because you do not run the risk of losing any money that you invest into the annuity, as long as the insurance company that sells it stays solvent. The insurer guarantees the safety of the principal. However, since fixed annuities have low risk associated with them, they also offer a relatively low reward. Other types of annuities have the potential to pay higher amounts than fixed annuities.
Investing in a fixed annuity is a good option for someone who is risk averse and is seeking safety of principal and steady income. They can be a good alternative to bonds, certificates of deposit, and similar investments.
Variable annuities carry greater risk than fixed annuities, but they also have the potential to provide greater return. When you purchase a variable annuity, you choose from a selection of investments, usually mutual funds, and the payments you receive from the insurer are contingent upon the performance of the investments you choose. Your account value will increase or decrease along with your underlying investment portfolio.
However, in the case of a variable annuity, the insurer provides insurance on your annuity in the event that your investments perform poorly and your account value decreases. There are multiple types of insurance that can be included in a variable annuity investment, some of which are included in the original contract and some of which are optional and can be added for an additional fee. These protection options include death benefits to pass any remaining money to your beneficiaries upon your death, guaranteed minimum income benefits that ensure a minimum rate of growth, and lifetime income benefits that guarantee you periodic payments for the entirety of your lifetime, even if your account balance goes to zero.
Variable annuities are advantageous because they enable you to potentially benefit from market performance by investing in equity investments rather than just receiving a fixed rate of interest. If the market performs well, you will receive higher payouts than you would receive with a fixed annuity while also receiving certain forms of protection from the negative implications that would occur from a market decline. Variable annuities also have their drawbacks, including the fact that there is risk associated with them because the underlying investments may lose value. In addition, variable annuities have the highest fees associated with them out of all the different types of annuities. While variable annuities offer the highest potential payouts, the annuitant also should consider any required fees before buying a variable annuity.
Variable annuities are a smart choice for retirees and pre-retirees who want the chance to earn capital appreciation in conjunction with the guarantee of life income, and are in a position to accept some downside risk on the payouts
An indexed annuity will pay you a guaranteed minimum amount, although a portion of your return is dependent upon the performance of a stock market index, like the S&P 500. You receive the low-risk appeal of having a guaranteed minimum return, but you also have the added opportunity to benefit when the financial markets perform well. Indexed annuities offer more growth potential than a fixed annuity, and they also present less risk (and therefore less potential return) than a variable annuity.
It is important to understand that, while indexed annuities are tied to the performance of a specific index, the annuitant will not necessarily obtain the entire benefit from any rise in the index. The extent that the annuitant can benefit from positive changes in the index is limited by the participation rate, which is how much of an index increase you actually receive. Further, most indexed annuity contracts include a yield cap or a rate cap that also can limit the benefit received by the annuitant.
Indexed annuities are advantageous in that they provide both the opportunity for growth and protection from market volatility. The annuitant’s principal is always protected and will not decline if the index performs poorly, and the annuitant has the additional opportunity to receive higher payouts if the market performs well.
The drawbacks of indexed annuities include high fees that may reduce your gains and that the gains will not reflect the entire increase in the value of the market due to the contractual caps on payouts. Apart from these drawbacks, indexed annuities also are complex financial instruments that the investor may struggle to comprehend.
Indexed annuities could be a smart buy for someone who wants to invest and have growth opportunities without bearing the full risk presented by the stock market. Nonetheless, it is crucial for an annuitant to fully understand all facets of an indexed annuity before making this kind of investment.
In summary, an annuitant can choose to make the annuity payout immediate or defer the payouts, and the annuity owner also must choose whether he or she wants the rate of return to be fixed, variable or indexed. In addition to these two choices, the annuitant can opt to add special options to the annuity to guarantee that his or her remaining annuity income is not retained by the annuity provider upon death.
There is no way to universally decide which type of annuity is the best for each individual. Rather, each individual annuitant must decide which options will be to his or her personal advantage and decide based on preferences and lifestyle.
Bob Carlson, who writes the monthly Retirement Watch investment newsletter and is the author of “The New Rules for Retirement: Strategies for a Secure Future,” provided information for this article.
Olivia Faucher is an editorial intern with Eagle Financial Publications.