The Different Types Of Annuities And How They Work

By Mark Di Vincenzo. May 7th 2016

Annuities have become very popular these days, especially with relatively conservative investors who feel shell-shocked by the recent volatility of the stock market. They are considered relatively safe retirement investments because they are generally (although not always) insulated from the performance of the stock market. However, not all annuities are built the same and not all of them are immune to the twists and turns of the stock market.

For a better understanding of how annuities might fit into your retirement planning, we’ll explain the basic principles of all annuities. Then we’ll define the three most common types of annuities and explain why they’re a good idea for some investors and not for others.

Annuities 101

When an annuity is purchased, the investor gives an insurance company a lump sum of money or sets up a recurring payment plan. In return, the insurance company gives the investor a fixed sum of money each year, usually made in monthly or quarterly payments. The payments can be received for a fixed amount of time or for the rest of the investor’s life. Alternatively, the investor can take a lump sum payment at a pre-determined date in the future instead of receiving the money in monthly or quarterly increments.

The actual amount of money the investor receives is determined by her age, life expectancy, the term of the annuity, the type of annuity, the amount of money she gives the insurance company and the current market interest rates.

The payments the investor receives are generally comprised of a portion of the principal investment made to the insurance company and the interest earned on that investment. The interest earned can either be a fixed rate or a variable rate that is tied to a mutual fund or a stock index. If the interest rate is fixed, the investor will be guaranteed to receive a fixed amount of interest over the life of the annuity and she will be able to calculate exactly how much money she will receive each month. However, if the interest rate is variable, the interest earned will depend on the performance of the underlying mutual funds or stock indices. Annuities with variable interest rates sometimes have caps that limit the amount of interest you can earn or lose.

There are two basic structures for annuities: immediate and deferred.

Deferred Annuities: If someone buys an annuity and wants to start receiving the payments at a later date, the annuity is called a deferred annuity. With a deferred annuity, interest on the money given to the insurance company grows tax-free which increases the total balance that will be paid out over the life of the contract. Taxes aren’t paid on the interest until the distribution period begins.

Immediate Annuities: If an investor gives the annuity company a lump sum of money and wants to receive payments right away, the annuity is called an immediate annuity. The interest that you earn over the life of the annuity will be taxed as it is distributed to you. However, because the payments start immediately, the money in the annuity will not grow as fast as it would if the payments were deferred. Therefore, all things equal, you can generally expect to receive smaller payments from an immediate annuity than you would from a deferred annuity.

Pros

  • Unlike 401ks and IRAs, there is no contribution limit for annuities.
  • Annuities can offer long-term or lifetime payments which can provide stable income to those who no longer work or have limited income sources.
  • They are generally considered safe investments when compared to other investment products.
  • The interest earned on annuities is tax-deferred until investors begin receiving payments. This allows for the money in the annuity to grow tax free until a distribution is made.

Cons

  • The fees charged by insurance companies for maintaining an annuity can be significant.
  • Some investors who choose lifetime payments lose out if they die young because their annuity company can keep the money that the investors’ heirs would have received.
  • Annuity companies pay large fees to financial advisers and others who sell their annuities to investors. Some annuity salesmen, many of whom don’t have licenses to sell equities and other financial products, sell annuities to people who might be better served by different investment products.
  • If you make withdrawals before you reach age 59 ½, you must pay the government a 10-percent early withdrawal penalty as well as tax on your earnings.

Variable Annuities

This type of annuity pays a variable rate of interest because of its exposure to investments similar to mutual funds. Instead of receiving a guaranteed fixed rate of interest, a variable annuity investor will receive interest based on the performance of the stocks or bonds that the annuity is tied to. If the stocks and bonds do well, the investor can benefit from a strong interest rate. However, if the stocks and bonds perform poorly, the investor can receive little or no interest on their investment.

Pros

  • The investor has a level of control and flexibility because he often has a choice of stock and bond funds in which to invest.
  • There is the potential for more growth compared with other types of annuities.

Cons

  • Because of its exposure to stock and bond investments, a variable annuity is the most volatile of the three main types of annuities. You can earn little or no interest on your investment if the underlying investments perform poorly.
  • The volatility can cause stress for investors.
  • The annual fees can be relatively high.

Fixed Annuities

This annuity pays out a fixed interest rate which guarantees a fixed return on the investment. The guaranteed return makes it very popular with the most conservative of investors.

Pros

  • Fixed annuities offer a predetermined return. You know what you’re getting, no matter what’s happening with the stock markets.
  • This type of annuity offers investors peace of mind, which can be a priceless thing.

Cons

  • There’s no potential for growth. If the stock market experiences growth, you won’t benefit from it.
  • Fixed annuities have high surrender charges, which are in place to prevent you from withdrawing money early. (Most fixed annuities allow you to access up to 10 percent of the contract value each year without having to pay the surrender charge.)

Indexed Annuities

The interest paid on this type of annuity is based on one or more of the major stock indices. For example, if your indexed annuity is based on the S&P 500 stock index, your return would be similar to the performance of that index.

Pros

  • It features caps on losses. If your indexed annuity is based on the Dow stock index and the index plummets, your losses will be much lower than someone who owns a mutual fund based on the Dow stock index.
  • If the underlying index performs well, you could receive a higher interest rate than you would from a fixed rate annuity.

Cons

  • It features caps on growth, so if your indexed annuity is based on the Dow and it soars, your gains will be much lower than that of an investor with a mutual fund based on the same index.
  • Annuity companies charge high fees for caps on losses, and many financial advisers consider it to be the most expensive annuity for investors.

Annuities can be a great investment vehicle for some people, particularly those who can’t stomach the ups and downs of the stock market. However, they are probably not the best investment for a younger investor who wants more growth potential in his investment portfolio. Therefore, it’s always a good idea to talk to a financial adviser before buying an annuity. This will help to make sure that the investment aligns with your overall retirement objectives.

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