Understanding the Different Types of Annuities
You’ve probably heard or read something about annuities – most likely in the context of planning for retirement. But the concept can seem more complicated than investing through a 401(k) Plan or an Individual Retirement Account (IRA). You might even think that as long as you have a 401(k) account or an IRA you don’t need to bother learning about annuities. But, the issue of how to put money away for your retirement isn’t an “either/or” choice – it’s more of a “yes, and what else can I do?” situation.
In this article, we describe the three types of annuities available to anyone who wants to invest in a tax-deferred vehicle to generate additional income in retirement. The three types are Fixed Annuities, Variable Annuities and Indexed Annuities. While they all have basic features in common, there are big differences between them. We mention some pros and cons of each, and stay away from confusing terminology as much as possible.
First, we quickly review the basics that apply to all types of annuities:
- Annuities generate income in retirement through tax-deferred investing. In other words, just like with a 401(k) or IRA, you pay no taxes on the returns your annuity earns until you start receiving payments, also called withdrawals, at a date in the future. As you receive your annuity payments, starting any time after age 59½, you pay taxes only on the investment income portion of those payments.
- Annuities provide guaranteed payments made at regular intervals – often monthly, sometimes quarterly, maybe annually – beginning at some date in the future. The more you invest in an annuity today, the higher your future payments.
- Annuities are a contract between you and an insurance company that guarantees the payments for the life of the contract. You’ll want to buy an annuity from a company that is healthy and strong, with a solid track record.
- An annuity can make payments for a set number of years. For example, payments could begin when you turn 65 and continue for 20 years. If you die before all of the payments are made, your beneficiary will receive the remaining payments for the guaranteed period.
- An annuity can make payments for the rest of your life. This type of annuity keeps making payments, even if you live to be 100+, although there is no “death benefit”, even if you die at a younger age than expected when you purchased the annuity. You can buy an annuity that continues to pay a beneficiary after you die, for the rest of his or her life; this is popular for married couples. The size of the payments depends on how long you (or both you and your spouse) are expected to live. The longer your life expectancy, the lower your payments.
- Surrender charges – During the period between the date you purchase the annuity and the date you start receiving payments (called the “accumulation phase”) it can cost you a lot in fees and penalties to access the money in your annuity. Why? Because the insurance company invests that money to allow them to make your minimum payments in the future and pay a commission to an annuity salesperson. If you take the money out sooner than planned, the company could suffer a loss. To protect against this, insurance companies imposes substantial “surrender” charges for early withdrawals. You would also most likely have to pay taxes, and perhaps penalties, on the returns your investments had produced up to that point.
That much is true for all three types of annuities. We now turn to the differences between them.
What is a fixed annuity?
The unique feature of a Fixed Annuity is that its payments stay the same, no matter what. It doesn’t matter whether interest rates change, or the stock market goes down or up, the payments from a Fixed Annuity stay the same. You know exactly how much you will receive every time, which can be a big help in figuring out how to meet your expenses in retirement.
What are the key features of a Fixed Annuity?
Fixed annuities are the most straightforward of all annuities, paying the same amount in every pament. The amount a Fixed Annuity pays depends upon a number of things:
- How much money you invest in the annuity – the more you invest, the larger the future payments.
- The rate of return you earn on the money invested in the annuity – the higher the rate of return, the higher the future annuity payments.
- How many years you wait for the payments to start – The longer you wait to start receiving payments, the more the money you invested in your annuity can grow, so the bigger your future payments will be.
- How many years you want the payments to last – the longer the annuity payments have to last, the smaller the payments will be.
The rate of return you can earn on a Fixed Annuity is typically lower than what you might earn on the other two types, Variable Annuities and Indexed Annuities. Why? Because the payments are fixed, no matter what happens to the stock market or to interest rates. Since the payments don’t change, no matter what investments earn in the markets, the insurance company behind those payments won’t promise you an unrealistically high return. In fact, if an insurer offers a fixed annuity rate that is much higher than what most other companies are offering, that could be a red flag.
Pros: In addition to the benefits of tax-deferred investing, fixed annuities provide steady retirement income that you can count on, no matter what, for the rest of your life. Fees are typically lower than for other types of annuities. A fixed annuity can be a good alternative to buying long-term care insurance; if you end up needing that type of care, your fixed annuity would help you pay for it. If you never need long-term care, you can use the annuity income for something else.
Cons: The rate of return is typically lower than what you earn over time with variable and indexed annuities. Also, since inflation means prices will be higher when you retire compared to where they are now, your fixed annuity payments will likely cover less in the future than what they would cover today.
What is a variable annuity?
With a variable annuity, you choose how the money in your annuity is invested. Typically, a variable annuity allows you to invest in a wide variety of mutual funds including U.S. equity and bond funds, global stock and bond funds, and funds that specialize in specific types of securities.
Variable annuities appeal to people who want to participate in the returns offered by the stock market, the bond market, or a combination of the two, understand the risks that go along with those types of investments, and also want some type of guaranteed income for retirement.
What are the key features of a variable annuity?
- The payments you receive depend on the performance of the investments you select. That can be good or not so good, depending upon factors including your knowledge of investment options, how many years you plan to wait before taking withdrawals, and how the markets perform while your annuity is in the “accumulation phase”.
- Variable annuities can include a “guaranteed lifetime withdrawal benefit”, often abbreviated as “GLWB” that combines the benefits of market returns with some level of guaranteed future income.
- Principal is guaranteed. With a variable annuity, although the value of the mutual funds you choose as your investments can fluctuate, your principal is guaranteed. That’s an advantage over investing directly in mutual funds, where you can lose some of your principal if you have to sell when the market is down.
Pros: Variable annuities allow you to participate in market returns while protecting your principal. A variable annuity with a guaranteed lifetime withdrawal benefit can be a good solution for people who like the security of a fixed annuity but want to benefit from returns offered by the stock and bond markets.
Cons: Variable annuities involve higher fees than fixed annuities. Why? With a variable annuity, the insurance company covers the risk that the return on your investments might not be sufficient to prevent loss of principal, and to cover your GLWB (guaranteed minimum benefit for life) if you chose that option.
What is an indexed annuity?
An Indexed Annuity, as the name suggests, provides an investment return linked to a stock market index. That index is usually the S&P 500, which tracks the returns on a portfolio of stocks of large U.S. companies. At specified intervals, an indexed annuity earns a percentage of the index return; that percentage is called the “participation rate”. The participation rate is usually in the range of 80%-90%, but can be as high as 100%, at least for the first couple of years, and could be as low as 25%. Some indexed annuities offer a high participation rate for the first few years and a lower rate thereafter.
What are the key features of an indexed annuity?
- Indexed annuities provide stock market participation without having to make decisions about which mutual funds use for your annuity investment. This can be a good approach for people who want the benefit of some stock market returns but are not comfortable making investment choices.
- When the stock market goes up, indexed annuities earn less than an investor who simply buys a mutual fund or ETF that tracks the index. However, in years when the stock market index declines, an indexed annuity earns a minimum rate of return, while the direct investor suffers a loss. A typical minimum rate guarantee is about 2%, but could be as low as zero, and perhaps as high as 3% percent.
- Indexed annuities protect annuity holders from a loss of principal, whereas investing directly in a mutual fund or ETF has no such guarantee.
- Most indexed annuities put a “cap” on the return credited to the annuity account in a given year. For example, a 9% rate cap means the maximum return the annuity can earn in a single year is 9%, even if the stock market index goes up by more than that. Rate caps vary across different annuities and typically depend on the length of the annuity payout period.
Indexing Methods. The return in an indexed annuity is based on the change in the stock market index over a given period. This can be computed in different ways, and has a big impact on the return the annuity earns.
- Annual reset – uses the percentage change in the value of the index, measured at the beginning and end of the year. Probably the most common method.
- High water mark – compares the highest level of the index during a period to the value of the index at the beginning of the period. The period is often one year, based on the anniversary date of the annuity contract. It may seem like this one offers the highest return possible, but it often has a cap that limits the return.
- Point to point – the index return is measured at the beginning and the end of a given period, which could be two years, three years, or even the entire period between the start of the contract and the date you start receiving payments. This approach could be beneficial if it avoids one or more years that would have generated low returns, but there is a risk that the end of the measurement period will be during a low point for the market.
Pros – An indexed annuity often earn more than a fixed annuity due to its stock market-based returns, and has a guaranteed minimum return to shield you from losses. It offers a way to participate in stock market returns without having to direct your own investing.
Cons – Indexed annuities are based solely on a single U.S. stock market index, which may not be best for investors who want to make their own investment choices. The indexing method can have a big impact on the actual return the annuity earns.
We hope this article has provided a clear summary of the three main types of annuities, including what they have in common and what makes them different from each other. Saving for your financially secure retirement is a long-term project, and an annuity can be an important part of that effort. Even if you contribute the maximum to your 401(k) or IRAs each year, it may not be enough to generate the level of income you want in your retirement. There is no limit on the amount you can invest in an annuity.
Our “What is An Annuity” guide explains the top five reasons people buy annuities. For information about annuity pricing, contact a few insurance companies directly, or work with a reputable broker who can explain your options and provide quotes from various insurance companies. An annuity may be the right approach for you to get where you want to be in terms of secure income for retirement.