What are the main kinds of annuities?

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October 2016
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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.

VARIABLE ANNUITIES:

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.

FIXED-INDEXED ANNUITIES:

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).

IMMEDIATE ANNUITIES:

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:

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.

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