All annuities are returns on an investment or insurance policy that are paid in regular installments, usually monthly and often for life. Within that broad definition, however, there are choices: either fixed or variable returns, and either an immediate or a deferred payment.
In any case, annuities are available through insurance companies and also can be purchased through banks and independent brokers.
- 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 fund it is invested in. The payments can go up (or down).
- An immediate annuity begins paying out as soon as the investor makes the lump-sum payment.
- A deferred annuity begins payments on a future date set by the investor.
An annuity is usually purchased to provide a regular income supplement after retirement, and a substantial amount of money is needed to generate a meaningful monthly income payment.
That makes it a major investment, so it's important to carefully consider the two big decisions below.
Fixed Vs. Variable Annuities
The money deposited in an annuity is invested along with the money of many other clients. Much like a mutual fund, the combined funds are invested in order to generate the returns that are used to make annuity payments.
And, as in choosing a mutual fund, the big question is how much risk you can tolerate.
In a fixed annuity, the money is invested in government bonds and highly-rated corporate bonds. These are the safest types of investments and guarantee a steady if unspectacular rate of return. Thus, the insurance company can commit to a set dollar payment every month.
The downside is that your payment won't go up even if the returns on bonds get better. The upside is that your payment won't go down even if returns on bonds fall.
Fixed annuities are a good fit for those with a low tolerance for risk. They are counting on that monthly income, and they don't want to take chances with it.
The Variable Annuity
A variable annuity makes payments that rise and fall with the performance of the investments that are made on your behalf.
Those who choose variable annuities are willing to take on some degree of risk in the hope of generating big profits.
You don't have to bet the farm, though. Investors in variable annuities can choose from a variety of funds, from very aggressive to highly conservative.
A fixed annuity suits the investor who wants a guaranteed income. A variable annuity fits the investor who can bear some risk or a lot of risk.
The downside is that your annuity payment can fall short at any time. The upside is that your annuity payment can go up at any time.
How much of those ups and downs you can stand determines whether you invest in a variable annuity and, if so, which fund you choose to invest your annuity in.
Variable annuities are generally best for experienced investors and for people who have a little wiggle room in their budgets from month to month.
Immediate Vs. Deferred Payment
This should be an easy question. Are you investing in an annuity because you need the income now, or are you arranging for payments to begin at a future date?
If you need a supplement to your income right now, you want the immediate payout option. If you expect you will need a supplement to your income in the future, for instance at retirement, you want the deferred payment.
There's a little more to it, though.
A deferred payment gives the money in your account more time to grow. And, much like a 401 (k) or IRA, the money deposited in a deferred annuity continues to accumulate earnings tax-free until it is withdrawn. You could have a more substantial income supplement when you finally start tapping into it.
An immediate annuity is just what it sounds like. The payments begin as soon as the lump sum is deposited.
There are other choices to make in arranging an annuity, and they depend entirely on your circumstances. These include:
- The term of the payments. You can arrange payments for 10 or 15 years, or for the rest of your life. A shorter period will mean a higher payment, but it also means a loss of income down the road. It might make sense if, say, the investor needed an income boost while paying off the final years of a mortgage.
- Spousal coverage. If you're married, you can choose an annuity that pays for the rest of your life or for the rest of your spouse's life, whichever is longer. The amount of the payment will be determined by the expected life span of the older partner. That may mean a slightly lower payment, but it protects both of you, whatever happens.