Annuities are contracts sold by insurance companies that promise the buyer a future payout in regular installments, usually monthly and often for life. Within that broad definition, however, there are different types of annuities that are designed to serve different purposes. The main types are fixed and variable annuities and immediate and deferred annuities.
- A fixed annuity guarantees payment of a set amount for the term of the agreement. It can't go down (or up).
- A variable annuity fluctuates with the returns on the mutual funds it is invested in. Its value can go up (or down).
- An immediate annuity begins paying out as soon as the buyer makes a lump-sum payment to the insurer.
- A deferred annuity begins payments on a future date set by the buyer.
The Purpose of Annuities
People usually buy annuities to supplement their other retirement income, such as pensions and Social Security. An annuity that provides guaranteed income for life also assures them that even if they deplete their other assets, they will still have some additional income coming in.
Fixed vs. Variable Annuities
Annuities can be either fixed or variable. Each type has its pros and cons.
With a fixed annuity, the insurance company guarantees the buyer a specific payment at some future date—which might be decades in the future or, in the case of an immediate annuity, right away. In order to deliver that return, the insurer invests money in safe vehicles, such as U.S. Treasury securities and highly rated corporate bonds.
While safe and predictable, these investments also deliver unspectacular returns. What's more, the payouts on fixed annuities can lose purchasing power over the years due to inflation, unless the buyer pays extra for an annuity that takes inflation into account. Even so, fixed annuities can be a good fit for people who have a low tolerance for risk and don't want to take chances with their regular monthly payouts.
With a variable annuity, the insurer invests in a portfolio of mutual funds chosen by the buyer. How well those funds perform will determine how the account grows and how large a payout the buyer will eventually receive. Variable annuity payouts can either be fixed or vary along with the account's performance.
People who choose variable annuities are willing to take on some degree of risk in the hope of generating bigger profits. Variable annuities are generally best for experienced investors, familiar with the different types of mutual funds and the risks they involve.
If the annuity buyer is married, they can choose an annuity that will continue to pay income to their spouse if they die first.
Immediate vs. Deferred Annuities
Annuities can also be either immediate or deferred, in terms of when they begin to make payments. The basic question buyers need to consider is whether they want regular income now or at some future date.
As with fixed vs. variable annuities, there are some trade-offs.
A deferred payment allows the money in the account more time to grow. And, much like a 401(k) or an IRA, the annuity continues to accumulate earnings tax-free until the money is withdrawn. Over time, that could build up into a substantial sum and result in larger payments. In annuity jargon, this is known as the accumulation phase or accumulation period.
An immediate annuity is just what it sounds like. The payouts begin as soon as the buyer makes a lump sum payment to the insurance company.
Deferred annuities can be either fixed or variable, as can immediate annuities.
There are some other important decisions to make in buying an annuity, depending on the individual's circumstances. These include:
- The duration of the payments. Buyers can arrange for payments for 10 or 15 years, or for the rest of their life. A shorter period will mean a higher monthly payment, but it also means that the income will stop coming at some point. That might make sense, for example, if the investor needs an income boost while paying off the final years of a mortgage.
- Spousal coverage. If the annuity buyer is married, they can choose an annuity that pays for the rest of their life or for the rest of their spouse's life, whichever is longer. The latter is often referred to as a joint and survivor annuity. Choosing the joint and survivor option generally means a somewhat lower payment, but it protects both partners, whatever happens.