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Annuity Products Vary
One of the reasons annuities have so many different features is that they are actually contracts between an annuity holder — also known as an annuitant — and an insurance company. Contracts have different provisions, different costs, different payouts, etc. The upside is an annuity can be personalized to fit your needs. The downside is the vast array of options can seem overwhelming to potential annuitants.
Annuity Costs, Benefits
The wide menu of annuity products can seem daunting to investors who are considering whether annuities make sense for their portfolios. Even more confusing is that each type of annuity can also have different options or “riders.”
And every rider has different costs and benefits.
Understanding the different types of annuities and how they work is crucial for investors to make the right decisions for their needs. This holds true whether you have an annuity and are considering selling the payments or are thinking about buying an annuity.
Main Types of Annuities
Fixed, variable and fixed indexed are the main types of annuities. Knowing what level of risk you’re comfortable with will help guide you through your annuity choices.
Interest-rate risk is a factor in determining the calculation of your payments. Low risk yields predictable payment amounts. Higher risk could boost your expectations.
|Variable||Tied to investment portfolio||Higher||Potentially higher or lower|
|Fixed Indexed||Preset minimum. Can change according to index like stock market||Medium||Won’t sink below set level.|
This is the option with the least risk and the most predictability. Fixed annuities come with a guaranteed, set interest rate that doesn’t vary beyond the terms of the contract. While other investments might soar or dive, the fixed annuity is steady. Sometimes, however, the interest rate will reset after a predetermined number of years.
A variable annuity comes with more risks and potentially higher rewards. The interest rate of variable annuities is tied to an investment portfolio. Payments from variable annuities can increase if the portfolio does well, but they can also decrease if the investments lose money.
Indexed annuities, also known as equity-indexed annuities and fixed-indexed insurance products, have characteristics of both fixed and variable annuities. It’s a way to balance the risks and rewards, carrying lower risks than variable annuities and higher income potential than fixed annuities. So the interest rate won’t sink below a preset amount. But the rate is also tied to a specified index, such as a stock market index, and can rise higher than a fixed annuity. The tradeoff is that this kind of annuity also has higher costs and fees than a fixed annuity has. And the methods for calculating interest are complex.
Annuity Payout Options
Another classification relates to when the annuity holder will start receiving payments.
Immediate Annuity (AKA Income Annuity)
With an immediate annuity, also known as an income annuity, the annuity holder begins receiving payments within a year after purchasing it. An example of this might be if someone wins a lottery or receives a large inheritance. The person may decide to use part of the money to purchase an annuity so he or she can shield part of the windfall from temptation to spend.
With a deferred annuity, the investor receives payments that start in the future. Typically, this happens when the investor retires. In the meantime, the investment grows on a tax-deferred basis.
How Long Annuities Are Paid
Generally, annuities protect against longevity risk. Annuities can provide guaranteed lifetime income, so the contract owner won’t outlive his or her retirement savings.
These are annuities that guarantee an income stream for the annuity holder’s lifetime. In some cases, lifetime annuities allow for a beneficiary to receive payments after the annuitant’s death. With these annuities, the amount of the payment will be set based on the health and age of the annuity holder.
This is because the payments are likely to continue longer for younger, healthier people.
An example of a fixed-period annuity, also known as a term-certain annuity, is a lottery prize. In many cases, lottery winners can elect to receive their windfall as an annuity. Those payments are spread out over a fixed period, typically 20 or 30 years. With these annuities, the age and health of the annuity holder do not affect the amount of the payments.
Other Annuity Choices
There are numerous ways to design annuity contracts to include provisions for the owner and of the annuity and their beneficiaries. For example, there are qualified and nonqualified annuities. This refers to whether the annuities are held in qualified retirement accounts and covered by the same laws regarding taxation and withdrawal requirements.
- Life-only annuities pay the length of the annuitant’s life and no longer. However, you can choose provisions that provide for your spouse or even a refund.
- Life annuities with period certain pay a certain number of years even if the annuitant dies before the end of the period.
- Joint and survivor annuities provide payments over the lifetime of both the annuitant and a beneficiary.
Secondary Market Annuity (SMA)
When an annuity holder needs access to funds tied up in the annuity contract, he or she can sell the rights to receive future payments on the secondary market. Often, these sales involve structured settlements. Structured settlements are settlements in legal cases that involve payments over time.
If someone is severely injured, for example, he or she might sue a company that manufactured and sold the product that caused the injury. In a structured settlement, the company would agree to pay a certain amount of money over a period of years.
Those payments are typically from an annuity issued by an insurance company. They are often structured or scheduled to provide a dependable stream of income, along with financial security, to the injured party.
Why Annuitants Sell
But then, if the injured person encounters expenses that exceed the amount of the payments, he or she might sell the rights to receive the payments to another company — an insurance firm or other entity.
The company would offer an amount lower than the value of the total payments.
Most states require factoring companies that purchase structured settlements to disclose this difference between the value of the future payments and the amount of the lump sum being offered to purchase them.
In addition to structured settlements, these transactions may involve other kinds of annuities, such as lottery prizes that winners elected to receive as annuities. When the lottery winner decides to sell a lottery annuity, they are doing so at a discounted rate.
Investors Benefit from Secondary Market Annuities
The company that purchased the structured settlement payments and other annuities may sell them to investors on the secondary market.
Investors who purchase annuity contracts on the secondary market may be attracted by the higher rates of return. These annuities contracts carry a lower risk that the issuing company will default on payments.
If you buy an annuity that was previously owned by someone else, you may get a better interest rate or higher payments than if you buy an annuity on the primary market.
Secondary market drawbacks
Also, once you buy an annuity on the secondary market, you won’t be able to sell those payments. The annuity, in other words, cannot be resold. Some critics say these purchases are best left to sophisticated investors.
23 Cited Research Articles
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