There are some features that all annuities have in common. However, each kind of annuity is a distinct product with a distinct purpose. Contracts can differ so much -- it's a wonder they all go by the same name!
People who own or are considering an annuity need to understand what type it is - or they might get stuck in a long contract that won't help them reach their retirement goals. In this section, we discuss the three ways to classify your annuity: by premium payments, payout timing, and investment options.
Classifying Your Annuity:
Not sure what this means? Click here. Our team of investments professionals can help.
Single premium annuities require a one-time investment at the beginning of the contract. A single initial investment is possible for any type of annuity, but the most common type of single premium annuity is an SPIA, or single premium immediate annuity.
The alternative to a single premium is to make contributions to a contract over time - the same way one might fund other retirement accounts. This is known as a flexible premium annuity. Commonly associated with variable annuities, the owner can add money to the contract each year or month depending on the insurance company. Some contracts permit the insurer to stop allowing future additions.
Immediate (or Income) Annuities
Income annuities let you convert a large sum of money into regular income payments, which may begin within one year. They can either last for a set time period (e.g., 10 years), or can be for life. The payment amount is effected by the lump-sum investment and the expected number of income payments.
Income payments are deferred for some period while the premium grows. Variable, fixed and indexed annuities generally fall into the category. Upon retirement or contract maturity, the contract value can either be taken as a lump sum or converted to an immediate annuity through a process called annuitization.
A fixed annuity generally guarantees a certain interest rate through the accumulation phase. It is chosen for its perceived safety and assurances. Similar to a Certificate of Deposit (CD), there is no volatility of principal. But this safety comes at a cost, including:
Rate of return is generally lower than other investment options.
Interest rate is not permanent. It can be reset at the end of pre-determined time frames (terms) – which are sometimes as short as one year.
In certain market conditions, you might get a better interest rate from a CD.
Meanwhile, the insurance company invests your premiums in an attempt to earn more than it then pays fixed annuity owners. The difference is their profit.
Variable annuities (VAs) are the most popular type of annuity. They allow you to invest premiums in a limited number of subaccounts, which are mutual fund-like investments bundled in an "insurance wrapper." Compared to other types of annuities, VAs have the highest return potential, but also the highest potential volatility and some of the highest annual fees.
VAs have some appealing features, including:
Earnings are not taxed until they are withdrawn.
You can buy optional enhanced benefits, called riders. These include lifetime income options, like guaranteed minimum withdrawal benefits (GMWBs).
Stock market participation – contract owners pick which funds to invest in.
However, each of these points must be considered carefully. They tend to come with costs, like:
When withdrawn, earnings are taxed as income, not capital gains.
VA fees can be substantial – often around ~4% per year. This dramatically reduces the real value of your gains.
Each subaccount charges an additional annual fee.
"Guaranteed income" may not be the best way to fund a retirement
"Guaranteed growth" is frequently misunderstood by salespeople and contract owners alike
Keep in mind that insurers have started placing some restrictions on the investments to control risk. For instance, they may require that a minimum of 30% of the assets be held in bonds, or 5% minimum in cash vehicles like money market funds.
We know this can be confusing. If you would like the assistance of an AnnuityAssist advisor, click here.
Equity-indexed annuities (EIAs), also called fixed-indexed annuities (FIAs), or more simply "indexed annuities" are similar to fixed annuities: they offer minimum and maximum interest rates that are based on stock market index returns. As such, the principal isn’t subject to volatility, but it still has some growth potential.
The name equity-indexed annuity is somewhat controversial, as it implies stock market (equity) participation. In reality, the stocks are used only as a "yardstick" to help calculate returns. Two other factors in the equation are participation rates and performance caps, both of which limit growth.
Generally, EIAs can outperform bonds… but underperform relative to stocks (see the comparison here). They generally have higher surrender fees and longer surrender periods than other types of annuities. Many insurance salesmen may try to lure you in with the promise of a bonus... but read the fine print. Bonuses are often subject to longer surrender periods. You may lose the money if you withdraw too early or fail to meet other conditions.
Want to receive more information like this? To join thousands of savvy investors who get research, case studies and tips like this regularly, enter your email address in the form on the right side of the page.