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.

Fixed Annuities

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.

Annuities are issued by insurance companies and can be offered through banks, independent brokers, and 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.

Variable Annuities

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.

The Advisor Insight

Joe Allaria, CFP®
CarsonAllaria Wealth Management, Glen Carbon, IL

Some less popular types of annuities include:

  1. Immediate Annuities, which ask for a lump sum and start paying an income stream immediately. These are most commonly used by investors retiring right away and desire a guaranteed income source.
  2. Indexed Annuities protect assets from market volatility, but they allow for growth that is tied to different stock market indexes, which can be subject to caps.

In the right circumstance, all different types of 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 appropriate type of annuity for your own investment objectives, because trying to make alterations after the fact could be very costly, or in some cases not possible.