There are a several kinds of annuities on the market, each with different terms and features. To select the best annuity product for your situation, you'll need to find the right combination of characteristics that will help you accumulate savings for your retirement, ensure you have a steady stream of income for a certain period of time even though you no longer work, or both. Below, we break down some of the basic kinds of annuities as well as the benefits and drawbacks of these products.
Types of Annuities
There are different types of annuities available for sale from banks, insurance companies, brokerage firms and mutual fund companies. Annuities can be fixed or variable, and they can be immediate or deferred.
With a fixed annuity, the insurance company guarantees the principal and a minimum rate of interest. The growth of the annuity’s value and the payments can be a fixed dollar amount or increase by a certain interest rate or formula. State insurance departments regulate fixed annuities.
In a variable annuity, money is invested in mutual funds that are only available to the company’s annuity investors. The amount you will be paid depends on the funds’ performance, net of expenses. As with any mutual fund selection, be sure to pay close attention to fund management fees, investment performance and risk. State regulators and the U.S. Securities and Exchange Commission (SEC) regulate variable annuities.
When insurance companies refer to immediate or deferred annuities, they mean the timeframe when they start paying you. With an immediate annuity, payments begin right away, but with a deferred annuity, payments may be arranged to start much later.
The time period over which an annuity is scheduled to pay also differs greatly. Some annuities pay throughout your lifetime, while others (known as period certain) pay for a set length of time, regardless of how long you live. For example, with a pure lifetime annuity, payments stop when you die, even if you pass away shortly after the payouts begin. There is also an add-on option to guarantee your beneficiaries will continue receiving payments for a certain amount of time after your passing, but this benefit can lower the payments you receive while alive.
Riders, such as a cost of living adjustment or a death benefit, can be added to annuity contracts at an additional cost to further customize them as well.
Advantages of Annuities
There are benefits of using annuities in retirement planning, according to the Insurance Information Institute. These include:
- Tax Deferral on Investment Earnings
Capital gains and investment income in annuities aren’t taxable until you begin receiving payments. Better yet, unlike IRAs and 401(k)s, there is no contribution limit for annuities. (However, if you hold your annuity within an IRA, these the limits do apply.)
- Protection from Creditors
Money in tax-deferred retirement plans is protected from creditors. If you own an immediate annuity, the most that creditors can access are the individual payments. In some states, the income from these annuities is also protected.
- Diverse Investment Choices
You can buy a fixed annuity that pays a specific interest rate or choose from stock and bond funds in a variable annuity. Some annuities offer floors that limit the declines you might encounter from funds in a variable annuity.
- Rebalance Without Tax Worries
You can sell stock and bond funds inside a variable annuity without incurring any taxes. That’s important since your risk tolerance changes over time as you get older and you rebalance your portfolio to be more conservative.
- Longevity Hedge of Lifetime Payments
The insurance company pools your money with many others who may not live as long as the life-expectancy tables forecast. That’s what allows the insurer to continue to pay you even if you live longer than anticipated.
- Protection for Your Heirs
In exchange for smaller payments, you can guarantee payments to your beneficiaries will continue for a certain period even if you die shortly after buying the annuity. Annuity payments that pass to beneficiaries don’t go through probate and aren’t governed by your will.
Disadvantages of Annuities
While there are benefits to purchasing an annuity, there are also some important drawbacks to take into consideration. These products tend to involve several different fees that may not be suitable initially or over the long term.
- Commissions
A broker or salesperson may collect a commission of up to 10 percent on your purchase. This is a powerful incentive for salespeople to push annuities over other products, regardless of what is the best option for a consumer’s financial situation. Direct-sold annuities are an exception, though, since these products are offered by investment companies that do not use insurance agents and therefore do not charge a sales commission. However, it is important to fully understand the ins and outs of these products before buying an annuity directly, since they are sold without the guidance and services of a knowledgeable salesperson.
- Limited Access to Your Money
Many deferred annuities feature a surrender period of a certain number of years. If you decide to withdraw money before this period elapses, you will incur surrender fees. However, with some contracts, you can make a withdrawal in the event of an emergency or take out up to 10 percent annually without incurring these charges. You may also be subject to a 10 percent premature distribution penalty if you make a withdrawal before age 59 1/2.
- Ongoing Costs
Products like variable annuities involve annual fees for managing your investment, insurance charges and additional expenses for any riders you may have added. This can become very expensive over the long term and may undermine the advantages of the annuity that you were drawn to in the first place. All fees should be clearly stated in your annuity contract.
For more detailed information on how different kinds of annuities work, consult the six-part Guide to Annuities offered by the Financial Regulatory Authority (FINRA).