Last Updated: January 2021
Annuities are not an altogether well-understood corner of the investment world.
Most people have heard the term but know very little about what they are and how they work.
We’re going to try to clear up some of the mystery of annuities, explain how they work, and describe the various types of annuities available.
By the time you’re finished reading this article, you’ll not only better understand annuities, but you’ll also begin to appreciate why they may – or may not – fit into your overall financial plan.
- What is an Annuity?
- Why Would You Want an Annuity?
- Types of Annuities
- Finding the Best Annuity Rates
What is an Annuity?
An annuity is less of an investment, like a mutual fund, and more of an investment contract offered by insurance companies. At the core, you invest a certain amount of money in an annuity, in exchange for the payment of an income for the future.
For example, you might purchase an annuity for $100,000 that will provide you with an annual income of $6,000.
The term of the income payout can be for a limited number of years, or even for the rest of your life.
There are many different riders which can be added to an annuity contract, to customize it to your own preferences.
Some examples include riders that will offer:
- Cost of Living adjustments (COLA) to the payments – increases the income payments based on increases in the consumer price index (CPI)
- Guaranteed minimum income benefit
- Impaired risk – increases the annual payout if you are determined to have a serious health condition
- Refund or return of premium – adds a death benefit to your annuity
- Long-term care – a provision to increase income payments if you require care
There are dozens of potential riders which can be added to an annuity, these are just common examples.
On the downside, annuities contain some provisions that you need to be aware of:
- You give up control of the money in an annuity.
- If you die before the annuity is depleted, the unpaid balance will be forfeited.
- Annuities have fees, and they are often steep.
- One fee of particular note is surrender charges. If you attempt to liquidate your annuity early, you may have to pay a large fee to do so.
Each of these limitations can be overcome, but you will have to add a rider to do so, and each will come with a cost.
Why Would You Want an Annuity?
Despite any potential drawbacks, annuities can work well in several situations:
- If you max out your retirement contributions, you can invest additional funds in an annuity. The contributions won’t be tax deductible, but the investment income earned in the annuity will be tax-deferred.
- An annuity can be set up like a pension for a person who doesn’t have a pension. It can provide a stable monthly income during retirement.
- Annuities typically provide an income for life. They will continue paying an income benefit, even if the annuity principle has been depleted. (This is the flip side of the situation described above, where undistributed annuity funds will be forfeited.)
- They’re perfect for people who are not familiar with investing. You can invest money in the annuity contract, receive a stable annual income, and not have to concern yourself with successfully investing the money.
Like any investment, an annuity requires measuring the benefits of the investment against the costs and risks.
They’re certainly not for everyone, but they can work well you’re in one of the situations described above.
It’s also important to understand that there isn’t just one type of annuity, but several.
Types of Annuities
There are 5 basic types of annuities you have to choose from:
- Fixed Indexed
1. Immediate Annuities
As the name implies, an immediate annuity is designed for someone who’s looking for an immediate income. You turn a lump sum of money over to an insurance company, and they begin paying you an immediate income.
The income payments can begin as soon as one month after the annuity contract is initiated. They’re sometimes referred to as single premium immediate annuities because you make a single large upfront payment – referred to as a premium in the insurance industry – and then begin receiving benefits.
Payments can be set up for a certain number of years, or for the rest of your life. Generally speaking, if the payments are of limited duration, they will be higher than if they’re payments for life.
Of course, age is also a factor.
An immediate annuity with benefits for life taken at age 75 may have higher income payouts than a 20-year term taken by a 55-year-old, due to longevity factors. These are very safe investments with higher returns than fixed-income investments like CDs and treasury securities.
2. Deferred Income Annuities
These annuities are referred to as deferred because income payouts begin well after the contract is funded.
They work much like IRAs in that you put money into the plan and it grows until payouts begin.
In fact, growth continues on the amount remaining in the contract, even after income payments begin.
And, once again, like an IRA, investment income earned on deferred income annuities is tax-deferred. (Though there is no tax deduction for your contributions to the plan.)
You can fund your account in at least two ways:
- You can either invest a lump sum and defer receiving income payments for several years or you can set up periodic funding, such as a certain amount of money contributed each year.
- The money in the contract will continue to grow, until income payments begin.
The insurance company will usually provide a minimum rate guarantee for the life of the annuity to ensure you’ll always have at least that much earning potential on the annuity.
Deferred income annuities come with different provisions and terms. For example, the deferral term could be 20 years with a 20-year income payout. Or you can have a 10-year deferral, with a lifetime income payout.
3. Fixed Annuities
This is the most basic form of an annuity. You invest a certain amount of money in an annuity contract, and you will be paid a specific income as a result. The income can be paid annually, semiannually, quarterly, or monthly.
In this way, a fixed annuity works very much like a traditionally defined benefit pension plan. Fixed annuities can be set up to pay benefits for a certain amount of time – like 20 years – or for life.
They can also be set up as either deferred or immediate, as described in each of the previous two sections.
A fixed annuity can be an excellent choice for anyone who has accumulated a substantial amount of money, but either lacks the ability or the desire to continue managing the portfolio. The fixed annuity will provide a steady income, without concern for the investment return on the contract.
4. Variable Annuities
Variable annuities can provide higher rates of return than other types of annuities, but they are more complicated investments. Your annuity will be invested in both stocks and bonds, which holds the potential for both higher returns and the potential for loss of principal.
Variable annuities are invested in insurance company mutual funds. Those can be invested in stocks, bonds, or industry sector funds. Since they are not publicly traded funds, you will not be able to get details and performance information from the usual sources.
Variable annuities are deferred annuities, which gives them an opportunity to grow in value. Like other annuities, investment income accumulates on a tax-deferred basis.
While they hold the potential to grow faster than other annuities and thus pay out higher income, they also come with risks. Perhaps the biggest risk is that investment returns are not guaranteed. If you invest your money, and the stock market goes into a prolonged bear market, this type of annuity could actually decline in value.
There are also limitations on when you can withdraw money from them, and it may be as long as 10 years before that can start. You’ll have to get all the details on a variable annuity when you get annuity rates.
There are significant variations in these annuities from one insurance company to another, especially relating to fees and surrender charges.
5. Fixed Indexed Annuities
If you’re looking at annuity rates, fixed indexed annuities should be a preferred search. These are probably the best annuities for the largest number of people.
Basically, these are fixed annuities which provide protection of both principal and interest. But they also give you an opportunity to participate in the financial markets. Unlike variable annuities, fixed indexed annuities provide a guaranteed annual minimum rate of return.
You can also tie one of these annuities to a certain stock index, like the S&P 500. If you do, the insurance company will give you the higher return of the two – either the guaranteed minimum rate, or the return on the index fund. It gives you participation in rising markets, but protection against declining markets.
For example, if the stock index rises by 10%, and you’re guaranteed minimum rate is 5%, you can take the index return. But if the market falls by 10%, you get the guaranteed minimum rate of 5%.
With fixed indexed annuities, you win no matter what market conditions are.
There is one downside to this type of annuity: In exchange for protecting you from loss, the insurance company also denies you full participation on the upside.
For example, they may cap the return on the index fund at 10%. If the index rises by 20% in a given year, you’ll get no more than 10%. The insurance company will keep the rest. Though it may sound unfair on the surface, the forfeited extra return is what’s used to provide protection against loss on the downside.
For conservative investors who are looking for protection against declining stock markets, this is a perfect annuity contract. What’s more, your principal value is fully protected, and there are no upfront commissions.
Finding the Best Annuity Rates
Annuities can be excellent investments – or they can be terrible. It all depends on your own particular needs and what you hope to accomplish with an annuity contract.
There’s also a wide variation in the terms, details, and annuity rates, between the many insurance companies that offer them. It’s always best to consult with an experienced insurance broker who works with many different insurance companies. That advice will make it possible to identify the strongest annuity plans at the best annuity rates.
A broker will also dramatically increase the possibility of finding the perfect annuity for your own particular circumstances. We’re insurance brokers, and we can help you find the annuity that will work best for you
Give us a call or fill in the “Leave a Reply” below, and put our experience to work for you!