What are the different types of annuities?
Lately, as the world focuses on market fluctuations and people look for security among their financial options, you might hear the word “annuity” being used a lot. But what is an annuity and how does it function? Are annuities good investments and, if so, for whom and under what conditions?
Put simply, an annuity is a contract — generally made in partnership with an insurance company — that provides regular payments to a recipient, who is known as an “annuitant.” The arrangement is a trade-off: The investor makes an investment upfront and, in exchange, receives a regular source of income for a specified period of time.
Annuities have grown increasingly popular over the past two decades. The Secure Act passed by Congress in 2019 increased access to annuities by encouraging businesses to include them as an option in workplace retirement plans. The value of U.S. retirement annuity assets climbed from $904 billion in 2000 to reach $2.19 trillion in 2017.
Why would someone purchase an annuity? The most common reason is to create a reliable source of income during retirement. An annuity can supplement other retirement income, such as Social Security and pension payments. In fact, according to AARP, only 20% of Americans who retire will receive income from a traditional pension, so there’s a real demand for a guaranteed stream of income among retirees. Annuities offer one way to meet that demand.
If you purchase an annuity, you can select an arrangement that lets you receive payments for 10 years, 15 years, or the rest of your life. The shorter the period you select, the higher your payments will be; the longer the annuity lasts, however, the longer you can keep receiving payments.
And the returns don’t have to be limited just to you, either. Annuities can cover more than one person’s lifetime: Benefits can be transferred to a spouse or child if the annuitant dies, and there’s often a death benefit if the owner passes away while the account still has value.
Seven Basic Types of Annuities
Annuities come in several forms and can be classified based on three factors:
- Their financial structure
- When payments begin
- How long payments last
Depending on what your retirement plans look like and the conditions you’ll be encountering, you can use different criteria to choose the kind of annuity that will work best with your goals. Let’s look at each of these in turn.
- You can assess the differing structures of annuities based on your tolerance for risk and the level of market exposure you’re comfortable or experienced with.
- Fixed annuities are your simplest option. They pay at a guaranteed interest rate (typically more than bank CDs) that can’t go up or down, so there’s no uncertainty about where you stand. On the plus side, you don’t have to pay maintenance fees — but on the downside, you won’t be making big money, either: Fixed annuities offer a modest rate of return. You’d choose this kind of annuity if you want to focus on security.
- Variable annuities put your money into mutual funds. Your rate of return on a variable annuity will vary, you’ll have to pay management fees, and your annuity could lose value. On the other hand, you could earn more instead, depending on what the market does. There’s a bigger risk here, but also the possibility of a bigger return. (If such uncertainty makes you wary, you may be able to purchase a rider that locks in a specific level of income even if the market does poorly. Read more about riders below.) Speak to your financial advisor to learn more about the potential benefits and pitfalls of this option.
- Fixed-index annuities (also known as hybrid or equity-indexed annuities) work like fixed annuities but offer an interest rate that’s the greater of
- A guaranteed minimum return or
- The return from a stock market index like the Dow Jones Industrial Average or S&P 500 (reduced by certain expenses and formulas).
- You can categorize annuities based on when payments begin.
- Immediate annuities are generally purchased by older people. Payments usually begin within one to 12 months of investment. They’re like life insurance policies in reverse. With an insurance policy, you make regular payments in exchange for a lump-sum payout to your chosen beneficiary. With an immediate annuity, you’re paying the lump sum in exchange for regular payments. When you retire, for example, you could take part of your 401(k) or IRA and convert it into an immediate annuity that gives you a monthly source of income. There’s usually no death benefit included, so if you die before you’ve used the money you’ve invested, your heirs won’t have access to it.
- Deferred annuities, sometimes called longevity annuities, are more often preferred by younger people. They’re deferred because they delay payments to a future date — generally two to 30 years later. In the meantime, your investment has a chance to grow, and your earnings won’t be taxed until you receive the money. You can purchase a deferred annuity by investing your principal via a lump sum payment or several deposits. Deferred annuities usually include a death benefit, so your beneficiary will receive what’s still in your account or a guaranteed minimum.
- You can classify annuities based on the duration of the payments you receive.
- Lifetime annuities pay income for the rest of your life (or yours and your spouse’s in tandem). The amount paid depends on how much you invested and when you started receiving payments. The main benefit with a lifetime annuity is that you can’t outlive your income.
- Fixed-period annuities, also called period-certain annuities, pay income for a specified period of time, say 10 or 15 years. The amount you receive doesn’t depend on how old you are when you start receiving payments; just how much you invest and how long the payments last.
The Pros and Cons of Different Annuities
As discussed, annuities aren’t all the same, so you don’t want to compare apples to oranges when discussing their advantages and disadvantages. Still, some general statements can be made about what they have to offer, and some very concrete pros and cons of annuities are recognized by the financial industry (even if not everyone agrees on their overall effect on a retirement portfolio). For more specific information, check with your financial counselor.
Pros of Annuities
Stability — Annuities offer predictability and guaranteed minimum interest rates. Plus, if you choose a lifetime option, you’re guaranteed not to outlive your capital. The fact that you can have income for life is a big plus, especially compared with other forms of investment, which can disappear quickly if the market goes south or you encounter unexpected expenses that drain your savings.
Simple structure — A fixed annuity can be a “set it and forget it” financial product. Because your funds are locked in, you don’t have to check the markets on a daily basis or decide when to buy, sell, or hold a given stock. This can mean you’ll worry less, especially if you’ve done your homework and know the insurance company backing your annuity is sound and stable.
Solid returns — Annuity returns can be higher than CD or Treasury rates. CD rates can also drop in a bad economy. Annuities, by contrast, can provide tax-deferred growth along with earnings that rack up interest not just on the principal, but also on the money you would have paid in taxes (which are deferred until you withdraw the funds).
In some states, annuities are also shielded from lawsuits, whereas CDs are nonexempt, which means creditors can go after them. Check your state’s laws and speak with a financial counselor to find out how things work where you live.
Tax deferral — Taxes on annuities are deferred until later in retirement when income is likely to be lower. (When you eventually make withdrawals, the amount you contributed to the annuity is not taxed, but your earnings are taxed at your regular income tax rate.) You also have some control over when you pay taxes. If you leave your funds in a deferred annuity, you can reduce your Social Security taxes, because you’ll have less taxable income when you postpone your withdrawals.
Cons of Annuities
Dependence on the issuer — Your level of safety depends almost entirely on the financial strength of the insurance company that issues it. Be sure to check state records and consult your financial advisor to be sure you’re making a sound choice.
No liquidity — When it’s in an annuity, your money is not liquid: You’ll face surrender fees and, potentially, tax penalties if you try to access it early. So if you think you’ll need your money in the next few years or before you hit age 59½ (for tax purposes), you should probably think twice about purchasing an annuity.
Not insured by FDIC — The Federal Deposit Insurance Corporation insures things like checking and savings accounts, as well as certificates of deposit. The FDIC does not insure annuities. Even though they’re sold at some banks, annuities are treated like mutual funds, stocks, bonds, Treasury securities, and other investments, and are not covered by the FDIC.
Lower ceiling — Because of insurance company fees and hedges, you’re likely to earn less from an annuity than you would if you invested directly in the market. The more safety you build into your annuity agreement, the less likely you’ll be to benefit from the market’s highs when it surges.
Fees — More fees tend to be attached to annuities than to mutual funds or CDs, especially when you consider the broker’s commission. You can, however, control some charges, such as what you pay for added features called riders. (For more on what fees and charges you can expect if you buy an annuity, see the FAQs section, below).
Inflation — Payouts can lose purchasing power over the years, thanks to inflation. In times when inflation is relatively low and stable, as it has been since 2008, not rising more than 2% annually, this is less of a factor than it would be in more volatile times. For example, inflation was in double digits in 1979 and 1980, and dropped below 3% just once between 1966 and 1991.
Even in times of modest inflation, the numbers add up: Prices in the U.S. were nearly 50% higher in 2020 than they were in 2000. If you’re concerned about inflation, you can purchase a rider with an immediate annuity. This could, for instance, guarantee your payments will increase by 3% a year — but as with any rider, it will cost you, lowering your initial payouts by 28%. (More on riders below.)
Important Factors to Consider
If you want to include your spouse in your coverage, you can select what’s called a Joint and Survivor Annuity. Under this arrangement, both spouses are guaranteed a stream of income. If one spouse dies, the survivor keeps receiving payments — but usually at a reduced rate of half or two-thirds the previous amount. In the case of a lifetime annuity, if your annuity covers the rest of your life and your spouse’s life, the payments would be stretched even further and, as a result, would likely be less.
Death benefits and beneficiaries
Surviving spouses and other beneficiaries have various options if they’re bequeathed an annuity. They can:
- Accept a lump-sum payment, but there’s a significant drawback to doing so. If the annuity has been held outside an IRA, every penny the owner earned in appreciation will be taxed just like regular income. Taking on those taxes all at once could push you into a higher tax bracket and make the hit on your bank account even worse.
- Take payments over a period of time up to the beneficiary’s life expectancy. This means a longer waiting period to receive funds — but with fewer tax consequences.
- Take withdrawals over a five-year period. Under this option, a compromise between the previous two, you can reduce your tax liability because the lower payouts will keep you from jumping into the higher tax bracket that would be triggered by a lump-sum payment. You’ll only be taxed based on the amount you’ve taken out in that particular year.
It’s important to point out that there’s a difference between leaving your annuity to a spouse and leaving it to someone else. A spouse can take over the stream of payments on an annuity under a process known as spousal continuation. The spouse can transfer the annuity into their own name and will then have the same rights, responsibilities, and options as the original annuitant.
The options for a non-spouse beneficiary, such as the annuitant’s child, are more limited. Such a beneficiary can’t change the terms of the contract and only has access to funds as designated in the original agreement.
As far as taxes go, similar rules apply to annuitants and their beneficiaries. As with the original annuity holder, a beneficiary won’t have to pay taxes until money is withdrawn from the annuity; a lump-sum payment, however, is immediately subject to taxes.
If you receive guaranteed payments as the beneficiary of a life annuity contract, the IRS advises you not to include any amount in your gross income “until your distributions plus the tax-free distributions received by the life annuitant equal the cost of the contract.” All later deductions, the agency advises, will be fully taxable.
Qualified vs. nonqualified funds
Taxes are deferred for all annuities as they grow, but there’s an important distinction between the two sources of income that fund them, labeling them as qualified or nonqualified annuities.
- Qualified funds haven’t been taxed yet. They come from sources like an IRA or 401(k). Your entire payout is taxed as income — the principal and the interest — and you have to start making withdrawals by a certain age.
- Nonqualified funds are money that’s already been taxed. Because you’ve already paid the IRS, your principal can’t be taxed again. The money you earn in interest, however, is still subject to taxation.
Single premium vs. flexible premium
The difference here lies in how the investment is made.
- A single premium is made in a lump sum. In this scenario, the entire sum begins accumulating interest immediately. Lump-sum payments work well following the sale of a major asset such as a home, or another type of windfall.
- With a flexible premium, by contrast, you can make contributions over a period of time. They’re “flexible” because you can change the amount or frequency of your input. Of course, since the money only begins appreciating after it’s deposited, the smaller/less frequent your contributions, the less you’ll get back.
Ratchet annuity (equity-indexed annuity)
A ratchet annuity is a fixed-indexed annuity that “ratchets up” each year to lock in that year’s stock market gains. It can only go in one direction: up. The benefit is obvious: You can ride along with the stock market’s gains, but you’re protected from its losses. You’ll never lose any of your principal. Sounds like a win-win proposition.
What’s the catch? In boom years for the market, you may not receive the full benefit of the surge. Ratchet annuities can be capped at various levels, some as low as 9%. If the market goes up 18% and you’ve got a 9% cap, for example, you’ll only earn half of the market’s windfall. That’s the price you pay for the security of protecting your principal.
Participation rate (index rate)
With fixed-indexed annuities, the participation rate determines the maximum amount by which a contract can grow. An insurance company sets a participation rate in order to guard against market volatility. For instance, it may set your participation rate at 80%, meaning your fixed-indexed annuity would earn 8% if the S&P 5090 rose by 10% for the year. In a less-volatile market, companies may provide higher caps.
FAQs About Annuities
FAQ: How safe are annuities?
Annuities are a contract with an insurance company, so they’re relatively safe — but they’re only as good as the company behind them. It’s worth noting that many businesses declined to offer their employees an annuity option in the past because they feared they’d be liable if the insurance company didn’t pay. More than 60% of businesses cited this risk when asked why they didn’t offer annuities alongside other options, such as straight 401(k) plans.
The SECURE Act, signed into law on January 1, 2020, protects businesses from this liability, encouraging them to offer annuity options. For the worker, this is good news in that it creates an optional guaranteed stream of income. However, it’s important to know that, if businesses are concerned about insurance companies failing to pay out on annuities, you should be wary, too.
Protect yourself by making sure you research the seller. (You may even want to consider splitting up your purchase among different companies.) Be sure to choose a company that has a solid reputation and is on firm financial ground. The longer it’s been around and remained in good shape, the more likely it will be to stand behind its contract.
Of the more than 2,000 U.S. insurance providers, a couple of hundred offer annuities. Four main rating agencies assess annuities: A.M. Best, Fitch, Moody’s Investors Services, and Standard and Poor’s (S&P). Each uses a different method of calculating its rating and a different grading scale. A.M. Best, for instance, rates its top picks as A++, with the scale going down to F. The top rating for Standard and Poor’s is AAA.
Do your homework and check with a certified financial planner. State guaranty associations can offer information about insurance companies and annuity salespeople. Website formats vary from state to state, but check in each site’s life insurance section.
It’s important to look into the individual seller’s record, too. All brokers who sell variable annuities must be registered with the federal government because annuities are considered securities. You can confirm whether a broker is registered by using a free search tool at Investor.gov.
A word of advice on sellers: Don’t deal with pushy sales representatives. Remember: Brokers are not neutral parties. They earn a commission for selling you an annuity. For more on this, see the section below on fees and charges associated with an annuity.
Fixed annuities can be a safe bet during a recession, but when the economy turns around, you won’t be reaping the benefits of that recovery. Before buying an annuity, make sure you read and understand the contract thoroughly. Again, talk to a financial advisor for more details on how to proceed.
FAQ: What fees and charges are involved with an annuity?
- Commissions are what the broker earns for selling you an annuity. They’re attached to each annuity, but they’re not typically part of the contract, and you don’t normally see the fee because they’re built in. (Some brokers will even boast, “I never charge a fee,” but that doesn’t mean you don’t pay them.) Commissions can be anywhere from 1% to 10% of the total contract value, depending on the kind of annuity involved. Here are some typical commissions:
- Commissions on single-premium immediate annuities, in which you pay a lump sum to the insurance company in exchange for guaranteed periodic payments, tend to be 1% to 3%. The commission is about the same for multi-year guaranteed annuities.
- Deferred income annuities, which allow you to defer your income stream indefinitely, generally range from 2% to 4%.
- The commission on a 10-year fixed annuity can range from 6% to 8%.
One way to get around commissions is by buying annuities straight from the insurer. These are known as direct-sold products.
- Riders are customized features tailored to your specific needs. You might want to include death benefits or minimum payouts, for example. As mentioned earlier, you might want to purchase a rider that guarantees you a certain income if you own a variable annuity and want to guard against downturns in the market. Each rider, however, comes at a cost: typically between 0.25% and 1% a year.
- Administrative fees are what you pay to manage or administer your annuity. They might amount to about 0.3% of your annuity contract’s value, or they could be a flat fee of, say, $25 or $30 a year.
- Mortality expense risk charges pay for the risk the insurance company takes in selling you the contract. You can expect it to be about 1.25% annually, and if there’s a profit, it can go toward the broker’s commission.
- Underlying fund expenses cover the costs associated with the administration of underlying mutual fund investments.
- Surrender charges and tax penalties can kick in if you sell your annuity too early or before you reach a certain age. Find more info on this below.
FAQ: Can you fund an annuity with IRA dollars?
Yes. You can roll over an IRA into an annuity, and you can do the same thing with funds from a 401(k). You’ll be creating a qualified annuity, and you won’t have to pay taxes when you do so. But remember: Because those dollars haven’t been taxed yet, the entire amount (principal and dollars earned via appreciation) will be taxable.
It also works the other way: You can move annuity funds into an IRA, but this only works with qualified variable annuities — those paid for with pre-tax dollars.
FAQ: Can you sell an annuity if the need comes up?
Before deciding to sell your annuity, you should check into potential contractual and/or tax penalties for doing so. Here are a couple of things to consider:
- The IRS charges an early withdrawal fee of 10% if you pull your money out of an annuity before the age of 59½. This is the same fee that’s assessed if you take early distributions from an individual retirement account or 401(k).
- Your insurer can charge you surrender fees if funds are withdrawn too soon.
Annuities can be broken down into two phases: 1) the accumulation phase, and 2) the annuitization phase. The accumulation phase, which typically lasts from four to eight years, is the time when the lump sum you deposited is supposed to be growing. The money accumulated will then be paid out during the annuitization phase.
If you decide to sell your annuity during its accumulation phase, the insurance company can hit you with a hefty surrender charge. Often, it’s larger the earlier you decide to sell. For example, you might be hit with an 8% penalty if you withdraw your money during the first year of an eight-year accumulation period; the surrender charge might be 7% for the second year, 6% for the third, and so on.
There’s no penalty for withdrawal if you become disabled or die.
Another option to consider is selling to a broker, but make sure you check first whether the broker is registered and reputable. Consult your financial advisor about this and other options if you want or need to sell an annuity.
FAQ: Will the insurance company keep all your money if you die early?
Yes and no. If you designate a beneficiary, the annuity can continue to provide a revenue stream for that person, as mentioned earlier. But this can cost extra. Otherwise, the money does go to the insurance company, which pools it with other policyholders’ money to help fund lifetime annuities.
In other words, if you die early, you won’t benefit from all the money you’ve invested, and if you die later than expected, you’ll benefit from money left in the fund by those who died early. It pays for insurance companies to have a good idea of how long you’re likely to live, so they generally do. They’re in the insurance business, after all, and annuities are a form of insurance: For ensuring that you’ll have a reliable stream of income, that insurance comes at a cost.
Think of it this way: You’ll never benefit from car insurance if you never get into an accident. And you may lose some benefits of an annuity if you die early. The principle isn’t exactly the same (for one thing, some level of auto insurance is mandated by law), but it’s similar.
Annuities can be a useful option to consider if you want a steady stream of income during retirement, won’t need to touch your money for a while, and want to minimize your tax burden by spreading out your income and keeping yourself in a lower bracket. On the other hand, if you know you’ll need access to your money in the near term, you might want to look at an alternative means of investment.
If you think an annuity is a viable option for you, be sure to do some research and talk it over with a financial advisor before taking the plunge. Also, be certain the insurance company and broker you choose are both reputable. If you plan judiciously, listen to sound fiscal counseling, and weigh the most appropriate options for your situation, you’ll be more likely to make the best decision possible for your financial future.