Most people are probably familiar with the concept of annuities. But did you know the products come in a variety of types and sub-types?
In part 1 of this series, we discussed the basics of annuities and some of the advantages and disadvantages. In part 2, we talked about the phases of annuity contracts. In this part, we’ll discuss the different types of annuities, keeping in mind that there are many subtypes within each of these types. Our goal here is to give you the basics, and to simplify the concept of annuities as much as is possible. Once you determine which type of annuity you’re interested in, you’ll want to do more in-depth research and perhaps consult a financial professional.
Immediate vs Deferred Annuities
An Immediate Annuity is just as it sounds—income commences within one year of purchase and will continue for either a specified period or for the life or lives of the annuitants, depending on the payout option you choose. Those options include:
A deferred annuity is so named because payout may be delayed, at the option of the owner, until much later in life. A deferred annuity gives you the potential to accumulate tax-deferred funds over time before you begin to receive payments. Because your money isn’t taxed until it’s withdrawn, it has the potential to accumulate more quickly. Then, when you withdraw money, you only pay taxes on the amount your investment may have earned above your principal.
Fixed vs Variable Annuities
Fixed annuities are CD-like investments issued by insurance companies. They pay guaranteed rates of interest. Fixed annuities can be deferred or immediate. Immediate annuities make fixed payments, determined by your age and the size of the annuity, during retirement. Fixed annuities are popular because they require low investment, fewer decisions from the annuitant, and because they are predictable. But fixed payments will not rise to keep up with inflation, so your purchasing power may erode. This is especially true if you retire young and collect payments over a longer period.
Also, “fixed” is a bit of a misnomer, as rates may drop after the first year. If you are unhappy with the new rate, you can withdraw your investment early, but it will be subject so potentially large surrender payments.
Variable annuities allow you to choose from a selection of investments, and then they pay a level of income in retirement that is determined by the performance of the investments you choose. Unlike their fixed counterparts, variable annuities can appreciate. As with fixed annuities, gains are not taxed until withdrawal. This potential growth could help you keep up with inflation. But, of course, they bring more risk. If the investments you choose for your annuity decline, the value of your annuity will also decline. There are also important tax implications for gains, plus a 10% penalty if you withdraw funds before age 59 ½.
In addition to potential surrender charges, taxes, and investment losses, variable annuities also have fees, and this is where the bad rep for annuities typically comes in. Sales commissions for variable annuities can run as high as 4%, and ongoing maintenance fees—including management fees—can run as high as 2-3% per year.
Variable annuities are potentially suitable for investors who have maxed out contributions to other retirement vehicles. Consider all the fees involved in a variable annuity, the claims-paying ability of the issuer, and the recent performance of the issuer’s funds, keeping in mind that past performance is no guarantee of future results.
That was easy, right?
So, an annuity is either immediate, deferred, fixed, or variable, right? Um….no. It’s either immediate or deferred. And it’s either fixed or variable. But annuities can be immediate-fixed, immediate-variable, deferred-fixed, or deferred variable. We’ll discuss those types in the next section and wrap up by debunking some common myths about annuities.