American consumers purchased more than $200 billion worth of annuities in 2017. There are many different kinds of annuities, each with its own set of risks and guarantees.
Being familiar with the menu of annuity options should enable investors to select a plan that is tailored to their financial needs. Annuities are sold by insurance companies, even though they are not actually insurance policies. There are several ways to classify annuities.
Understanding the categories can arm an investor to navigate this sometimes confusing array of choices to select an annuity that best fits the investor’s needs and risk comfort level.
These classifications relate to when payments are made, how the money is invested, how long payments last and how the annuity was obtained.
The main types of annuities are defined by when you begin receiving payments relative to when the annuity is purchased and how the payments are determined.
These main types are:
Within each main type of annuity, there are different options to consider, such as how long the payments should last and whether they should go to a beneficiary upon your death. Often these selections involve purchasing riders, which increase the cost of the annuity.
With immediate annuities, payments start being made to the annuitant within a short time of the annuity contract — no later than a year after purchase.
This is often the choice for people who buy annuities at retirement to supplement retirement income, such as pensions and Social Security.
This kind of annuity is described as the mirror image of life insurance, which involves periodic payments and a lump sum payout at death.
With immediate annuities, a lump sum is used to purchase the product. The annuity provides periodic payments that end at death or after a specified period of time.
With deferred annuities, as the name suggests, payments begin at a later time, typically at retirement. In the interim, the size of the annuity increases as the investment grows tax deferred.
The payouts for these annuities can be much higher than immediate annuities because the investment builds before the payout period begins.
One big risk with deferred annuities is that the investor won’t live long enough to begin receiving the payout.
Should the need arise, a deferred annuity may be converted to an immediate annuity if the owner needs to start collecting payments.
When you purchase a deferred annuity, you can pay a lump sum or make period payments. When you pay a lump sum, this is known as a single premium annuity. When you make you make multiple payments, it’s referred to as a multiple premium annuity.
Qualified annuities allow the annuitant to get money from qualified retirement plans before taxes. Nonqualified annuities are purchased with money that has been taxed before and pay annuitants after-tax dollars.
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Both immediate and deferred annuities can be designed for different payout needs. Some investors don’t want to outlive their annuities, while others want to leave money for loved ones.
A life only annuity pays income for the lifetime of the investor and stops at death. This is usually preferable for annuitants who have no dependents or who have provided for their dependents in other ways. This also works when the dependents have sufficient resources of their own. This option provides the investor with the highest income and lowest cost.
A life annuity with period certain is similar to a life annuity, but includes payments for a minimum number of years, even if the annuitant dies early in the payments. This period is typically 10 or 20 years. If the annuitant dies within the time period, his or her beneficiary will continue to receive payments until the end of the pre-set period.
If the annuitant lives longer than the period, he or she will continue receiving payments until death. This is also known as a life annuity with a guaranteed term.
A joint and survivor annuity involves payments as long as the annuitant and his or beneficiary lives. Annuitants can decide that payments after their death may decrease or may stop after a selected period of time.
Once an investor chooses between an immediate or a deferred annuity, he or she can then decide how the annuity funds should be invested by the insurance company. Much will depend on the investor’s comfort with different levels of risk. The options here are fixed, indexed and variable annuities.
With fixed annuities, the payout is a pre-determined sum of money that doesn’t change from the contract agreement. The fixed annuity is the most predictable and stable of all the annuity types. It carries the lowest risk, and possibly a lower return for the investor. The funds for fixed annuities are kept in the insurer’s general account. Still, sales exceeded $100 billion for the third year in a row for the first time.
The fixed annuity contract may specify that the payout amounts increase over time, but the change won’t be tied to any investment performance. These are also known as multi-year guarantee annuities. The insurance company that provides the annuity determines the payments by taking into account the annuitant’s age, gender and the amount of the payment. The annuity provider guarantees the principal and a minimum rate of interest. The annuity value may grow by a fixed dollar amount or an interest rate or some other agreed-upon formula. If the annuity provider has a better-than-expected year, it may pay additional policy dividends to annuity holders.
With variable annuities, the money is invested in a fund of professionally managed investments like stocks, bonds or money market funds. Investors who purchase variable annuities can choose from a selection of subaccounts, which are mutual funds. The performance of the annuity will be determined by how well the individual funds perform. Payments can be determined by the performance of the market or investments, or some combination. Investors can purchase riders to guarantee a certain income level regardless of how the funds do.
In 2017, investors purchased $95.6 billion worth of variable annuities, according to the LIMRA report. This was 9 percent lower than the previous year.
It was the first time in 20 years that the total purchases fell below $100 billion.
Variable annuities can be complex and difficult to understand. They can be very different from company to company and in different time periods. Financial advisors caution that salespeople earn high commissions on this type of annuity and may pressure investors to buy them. They can carry high annual fees of 3 to 4 percent and severe surrender penalties.
Indexed annuities are investments in equity-based indexes such as the S&P 500. Indexed annuities are considered a type of fixed annuity.
Indexed annuities also have a guaranteed rate of return even if the index doesn’t do well.
These annuities frequently have a limit or cap on earnings, so if the index does really well, the annuitant won’t get the entire return. This is to enable the company to provide a guaranteed rate of return. In 2017, consumers purchased $57.6 billion in indexed annuities. This was a decrease of 5 percent from 2016, the first decline since 2009.
