What are the main kinds of annuities?
While there are different types of annuities, they all boil down to essentially the same thing: an insurance contract that offers guaranteed income, often for life and sometimes with some capital appreciation. Annuities are meant to supplement income from a traditional stock and bond portfolio. Annuities are by their nature illiquid and as such, it is never advisable to invest more than 50% of an investment portfolio in annuities. Annuities make the most sense as an investment vehicle for pre-retirees and retirees who wish to minimize concerns regarding the potential impact of a bear market while they're living on the retirement portfolio. Annuities provide retirees with assurance they will have a specified stream of income, regardless of how the markets perform. They offer certainty in an uncertain world. There are hundreds of annuities on the market. They typically provide higher income than bonds, but many have materially higher fees and their payments - reflecting today's ultra-low interest rate environment - aren't as attractive as they once were.
5 PRIMARY TYPES OF ANNUITIES -
FIXED RATE ANNUITIES (ALSO CALLED MULTI-YEAR GUARANTEE ANNUITY OR "MYGA"):
These are fixed interest investments issued by insurance companies. They pay guaranteed rates of interest, typically higher than bank CDs, and holders can elect to defer income or begin to draw income immediately. A Multi Year Guaranteed Rate Annuity (MYGA) pays a constant and guaranteed rate of interest each year during the selected period. The annuity investor can either spend the interest as income, or allow it to compound inside the contract on a tax-deferred basis. Benefits of standard fixed rate annuities are their simplicity and predictability of the income stream, allowing for many different uses including RMD distributions, wealth transfer and accumulation. As with any annuity it’s important to understand the differences between annuity products. A common mistake is taking the highest interest rate without considering the liquidity provisions and duration of the commitment.
Standard fixed rate annuities have no fees.
A variable annuity is a contract between you and an insurance company. You open an account with funds typically earmarked for your retirement. The insurance company then invests your money in a selection of mutual fund-like investments (subaccounts), and your account value can grow or shrink with the underlying investments. Available fund subaccounts typically range from conservative bond funds to aggressive stock funds, in addition to asset allocation models.
These allow investors to choose from a basket of subaccounts (mutual funds). Ultimately, the value of the account is determined by the performance of the selected mutual funds. A rider can be purchased on top of this to lock-in a guaranteed income stream regardless of market performance, which is a critical hedge in the event the mutual funds perform poorly. These are popular among retirees and pre-retirees seeking a greater shot at capital appreciation in conjunction with guaranteed lifetime income.
Variable annuities can vary widely in their fund and benefit offerings as well as fees, so be certain to hire a qualified, professional financial advisor with a thorough understanding of annuities prior to purchase.
Among the various types of annuities, variable annuities typically have the highest fees.
A fixed-indexed annuity is a type of annuity that grows at the greater of (a) an annual, guaranteed minimum rate of return; or (b) the return on a specified market index (e.g. the S&P 500), less certain expenses and formulas. At contract opening, a term is selected, representing the number of years required to pass before the principal is guaranteed and the surrender period has passed. In a robust equity market, you will not achieve the actual index performance due to the formulas, spreads, participation rates, and caps applied to fixed-indexed annuities, and also due to the absence of dividends (see below). But, in a down market, you never lose any of your principal investment. Many investors find that fixed-indexed annuity returns more closely approximate CDs, traditional fixed annuities, or high grade bonds, but with the potential for a small hedge against inflation in an up market.
Fixed income annuities relative to the other types have moderate fee levels.
FIXED VS. FIXED-INDEXED ANNUITIES:
Technically speaking, fixed-indexed annuities are a type of fixed annuity. But a fixed-indexed annuity is different than a standard fixed annuity in the way that earnings are credited to the annuity. For a standard fixed annuity, the issuing insurance company guarantees a minimum interest rate. The focus is on safety of principal and stable, predictable investment returns. With fixed-indexed annuities, the contract return is the greater of a) an annual minimum rate, or b) the return of a stock market index, less fees & expenses and other items mentioned previously. If the chosen index rises sufficiently during a specified period, a greater return is credited to the owner’s account for that period. If the stock market index does not rise sufficiently, or even declines, the lower minimum rate is credited (usually 0% – 2%). The owner is guaranteed to receive back at least all principal less withdrawals (provided of course that the owner has held the contract for the minimum period of time specified in the contract).
These are essentially equivalent to a life insurance policy. Instead of paying regular premiums to an insurer that makes a lump-sum payment upon death, the investor gives the insurer a lump sum in return for regular income payments until death, or for a specified period of time, typically starting one to 12 months after receipt of the investment. Payments are typically higher than other annuities because they include principal, as well as interest, and so also offer favorable tax treatment. These are popular among retirees and pre-retirees who need a higher-than-average stream of income and are comfortable sacrificing principal in exchange for higher lifelong income.
Immediate annuities have no fees.
Deferred annuities delay payments until a future date, greater than one year from contract initiation. These annuities enable individuals to increase their income stream later in life for less money, as the insurance company isn’t on the hook for as lengthy a period of time when income payments are deferred. These people to those seeking guaranteed income in the future but do not need anything now and/or those seeking to build a ladder of income over different periods later in life. For instance, an individual may want to work while retired but knows that eventually, they’ll be forced to stop working and at that point, but not prior to that time, they will need income from an annuity.
Relative to other forms of annuities described above, deferred annuities have moderate fee rates.
There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment generates returns. However, within these categories are immediate and deferred payment annuities, for a total of four basic annuity types. Like most investments, the ins and outs of annuities can be somewhat overwhelming for the beginning investor. A firm understanding of these four basic classes of annuity goes a long way in ensuring you select an investment that adequately meets your needs.
A fixed annuity is an investment that provides a set payment amount each year in exchange for a given number of purchase payments. Depending on the specific investment, an annuity may require one up-front payment or a number of payments over time.
All annuities are offered through insurance companies, though they are not insurance policies. In a fixed annuity, the insurance company pools the purchase payments of many account holders and invests them in government-issued bonds or highly rated corporate debt. These types of investments are considered very secure and generate a guaranteed rate of interest, so the insurance company is able to pay a fixed amount of income to each annuitant each year. However, in fixed annuities, the insurance company guarantees your initial investment and a fixed rate of interest regardless of market fluctuations.
Fixed annuities are especially good for those with low risk tolerance who prefer to have their capital protected from loss even if it means sacrificing the opportunity for larger profits. Investors who do not have much to lose but want to be proactive about their financial futures can also benefit from a fixed annuity.
Unlike fixed annuities, variable annuities provide irregular payments based on the performance of the underlying assets. Rather than investing in highly secure bonds and other debt securities, variable annuities generate income from a variety of specifically designed investment funds managed by the insurance company.
Much like mutual funds, these funds are geared toward different investment goals depending on annuitants' needs. The owner of a variable annuity may choose to invest in whichever fund is most profitable and carries the appropriate amount of risk for his personal investment style. For example, aggressive investors who want to see big profits and are willing to take on more risk to get them can choose a fund that invests in cutting-edge stocks in an effort to generate the biggest gains. The trade-off is the annuity loses value and may provide little or no income if the fund performs poorly.
Variable annuities are generally best for experienced investors who have a little wiggle room in their finances. As with any potentially volatile investment, the potential for profit is much larger than with the more stable fixed annuity but so is the potential for loss.
Immediate Vs. Deferred Payment
In addition to the two different investment types, most insurance companies also offer two different payout options. With immediate annuities, the annuitant begins receiving income immediately after making a single lump sum investment. Payments can be made over a specific period, such as 10 to 15 years, for the life of the annuitant or for the life of the annuitant and his spouse. Often, this option is used by those who are already retired and need to generate regular income quickly.
More common for younger investors who have time to let their investments grow, deferred payout annuities do not begin paying until a set date, usually at retirement. The benefit of deferred annuities is the investment accumulates earnings tax-free until those funds are withdrawn after retirement, much like with a 401(k) or IRA.
As other advisors mentioned annuities are insurance products/ contracts that you can purchase as fixed (get a certain interest rate each year), variable (where you take on the risk of return by selecting offered mutual funds) or a hybrid of the two where your return is tied to a benchmark like the S&P 500. Each type and company costs can vary greatly. Be sure to understand the costs you are paying each time you add money and the behind the scenes costs,such as, mutual funds expense fees, contract fees, mortality and expense fees, commissions, the options you choose as well as other costs. Also, be aware of any surrender penalties involved. The fees behind the scenes are found in the prospectus and are easily found if you look for them. Annuity expenses are taken from your returns, since you get net return on investments so understand the cost of how your money is being earned. As a side note, there are also no load annuities where costs can be significantly less. Each annuity has its positive and negatives, so carefully analyze and understand what you want and shop for the best fit. Most annuities should be considered long term investments.
Due to the complexity of this topic, I will keep this very simple. Here are a few different types of annuities in the marketplace.
1. Immediate Annuities: Invest a lump sum and start drawing an income stream immediately. Used often for those retiring immediately and wanting more guaranteed income.
2. Deferred Annuities: Invest a lump sum, but don't start drawing an income stream for a few years (to be decided by the annuity purchaser). The annuity will likely provide some growth benefits during the deferral period.
3. Fixed Annuities: Purchase an annuity and tie it's growth to a fixed rate of interest. These are protected from down swings in the market.
4. Variable Annuities: Purchase an annuity and tie it's growth to the performance of the annuity's underlying sub-accounts (which act like mutual funds), which means that these annuities are not protected from market volatility (and they also have historically high fees).
5. Indexed Annuities: A combination of sorts, with these types being protected from market volatility (like a fixed annuity), but they allow for growth that is tied to different stock market indexes (like a variable annuity). Before you think it's too good to be true, indexed annuities often have caps on their growth. So, while it may sound nice to have "the upside potential of the market without the downside risk," that is usually not an accurate depiction of how these annuities will perform.
In the right circumstance, all of the above annuities can be effective tools for an investor. However, because of their more rigid, inflexible provisions, it is important to make sure that you are purchasing the RIGHT type of annuity beforehand, because trying to make a change after the fact could be very costly, or even not possible.
Joe Allaria, CFP®
In the most technical sense, the actual annuity is a stream of payments over time, but the way people generally talk about annuities as a product refers to a few different mechanisms that lead to that stream of payments. You can break the overall annuity market into two big categories:
- Immediate annuities: these take an amount of money and convert it into a stream of payments right away; the structure of those payments can vary across a range of options, with some common options being "for the life of the annuitant" or "for a minimum of X years or the life of the annuitant". While there are many different insurance companies offering this type of product, and with a number of options on how to structure the payout, this type of annuity and the math behind it is relatively simple
- Deferred annuities: this type of product takes either a lump sum or series of contributions in the present with the intention to create the stream of payments at a later date. The general idea with these is that the person buying the annuity is saving up over time to accumulate enough money to produce a stream of income sufficient to support their retirement spending (or similar financial goal). The growth on those contributions over time may be tax deferred. Within this category, there are a number of types of annuity products that range along a spectrum of complexity, risk, and potential reward. What follows is intended to be a high level list, not a comprehensive review of the deferred annuity market:
- "fixed" - this type of deferred annuity will generally have single, nominal rate of return applied to the contributions over time. For example, the insurance company may offer to pay a 3% fixed return on an annual basis to any contributions made under the contract; in this scenario, in very simple terms, $1000 contributed to the annuity would stand to earn $30 over the course of the following year.
- "variable" - in this version, the insurance company does not offer a fixed rate of return, but provides access to market based investments such as mutual funds within the annuity. These mutual funds embody many of the risks and potential rewards of the underlying markets or investments they track, and so the return for the annuity over time is "variable".
- "indexed" - these are similar to the variable annuity products in some ways, as the returns are not fixed, but vary over time per a formula that tracks an underlying market index
Regardless of the type of annuity under consideration, it is well worth the effort to understand all of the fees, restrictions, caps on upside return, "surrender fees", etc that are stipulated in the specific contract.