Annuities remain a popular choice for many people, especially those planning for retirement, because they offer a stream of income that can be used to fund your lifestyle. Annuities can offer consistent monthly income, and they can pair well with other forms of regular income such as Social Security, potentially helping you maintain your budget and offering a worry-free source of money.
“Annuities can be powerful tools when deployed systematically as part of a well thought out retirement plan, that can allow you to keep or in some instances increase your standard of living,” says Ed de la Rosa, certified financial fiduciary and founder of Solid Ground Financial, a financial advisor based in the Tampa area. “Steady, guaranteed income for the rest of our lives is what provides us with peace of mind and financial tranquility.”
Annuities are a written contract between you and a life insurance company. You fund the contract, either with a lump sum or a series of payments, and in exchange, the insurer promises to make a series of guaranteed payments back to you for a specific time or for the rest of your life, depending on the contract’s details. Annuities are notorious for their hefty fees and complicated contracts, so it’s important to be aware of how the annuity is structured.
Annuities are highly customizable and can be structured in many ways, including added lifetime income protection and even a death benefit. Annuities are tax-deferred, so you won’t owe income tax until you begin receiving payments.
Here are the five most popular types of annuities, as well as some drawbacks of annuities.
5 popular types of annuities
Annuity types are categorized based on the way money within the account grows and when annuity payments begin. Fixed and variable describe how money grows within the account while immediate and deferred indicate when payments begin. Any annuity can be customized further with riders, or additional benefits or features added to a contract at a cost.
“Finding the right annuity is a process that should not be taken lightly,” says de la Rosa. “Not only should you methodically choose which type of annuity to deploy, but you should carefully research the financials of the insurance company as well. Once you find the right strategy, choose the insurance company with the best financials that makes the strategy you need available.”
1. Fixed annuity
A fixed annuity is the most straightforward kind of annuity. It offers a contractually guaranteed rate of return on your investment and will pay out over a specified period of time.
Advantages: You’ll know the rate of return you’re getting when you set up your annuity, helping you plan your budget.
Disadvantages: The purchasing power of a fixed amount of income each month will decline over time as inflation eats away at it.
2. Variable annuity
A variable annuity allows you to get a payout that may grow over time by investing your money in various mutual funds or other funds that hold stocks, bonds and other assets. How much you receive depends on the performance of the investments. Some variable annuities offer a guaranteed minimum income benefit and many impose a maximum cap on what you can earn. The investments themselves will also charge fees as a percentage of your investment in the fund.
Advantages: A key benefit here is the potential to invest in assets that may appreciate over time to account for inflation and increase your income stream. A guaranteed minimum benefit can also help protect your downside if the investments don’t perform well.
Disadvantages: Investment expenses can be high relative to what you would pay investing in similar funds in the stock market. You can lose money and there is no step-up in the funds’ cost basis when it’s inherited.
3. Fixed indexed annuity
With an indexed annuity, your investment tracks the rate of return on an index such as the S&P 500, which contains the stocks of hundreds of America’s top companies, though it’s not actually invested in that index.
“The performance of your funds may be tied to how well an index may perform but your funds are not in that actual index,” says de la Rosa. “Because it’s not an investment, the good news is that you can’t lose your principal. And for every year your annuity grows, your gains are locked in.”
Advantages: The key benefit here is that you can’t lose your principal and your gains are locked in.
Disadvantages: Index annuities impose participation rates or interest rate caps, so you won’t fully capture the upside of strong bull markets. So if the S&P 500 gains 15 percent one year, but your interest rate cap is 7 percent, your returns will be limited to 7 percent.
4. Deferred annuity
With a deferred annuity, you agree to start your payouts at some future point. So a deferred annuity is not so much a separate kind of annuity as it is a feature of annuities generally. That means you could have a deferred fixed annuity, for example, that begins fixed payments in the future rather than immediately.
Advantages: A deferred annuity helps you set up an income stream when you need it, typically in retirement. You can fund the annuity over time, instead of with a single lump sum.
Disadvantages: A deferred annuity does not offer any particular disadvantages apart from the general type of annuity it’s associated with (fixed, variable or indexed).
5. Immediate annuity
With an immediate annuity, you agree to start your payouts within one year or less after depositing a lump sum. Like a deferred annuity, an immediate annuity is less a separate kind of annuity and more a feature of annuities generally, so you can have a fixed immediate annuity or a variable immediate annuity.
“An immediate annuity will start paying income usually thirty days after issue but no more than a year after the effective date of your annuity, depending on what you choose,” says de la Rosa.
Advantages: The immediate annuity allows you to turn on an income stream quickly, helping you set up cash flow now.
Disadvantages: The key disadvantages of an immediate annuity are tied to the general type of annuity it’s associated with (fixed, variable or indexed). But you’ll need to deposit a large lump sum to achieve any substantial level of immediate income.
Other features of annuities
Besides these general types of annuities, customers can add other benefits — called riders — to their annuity contract. Adding features to the annuity will drive up costs, which could reduce your potential payouts down the line. These features include:
Death benefit
Many annuities offer what’s known as a death benefit, which can take two forms:
- A payout of the remaining balance: This type of benefit goes to the annuitant’s beneficiaries as named in the annuity contract. It consists of the remainder of the assets in the annuity.
- A benefit on the annuitant’s death: On the annuitant’s death, the annuity may be structured to pay out a certain amount, say $10,000, as a kind of life insurance benefit.
Lifetime income for a spouse or heir
Annuities can be structured in a variety of ways, and while it’s common that an individual sets up the annuity to provide themselves with lifetime income, it’s possible to include others, too. For example, a husband may set up an annuity with survivor’s benefits to provide income not only for his lifetime but also for his wife’s, ensuring that they don’t outlive their income.
Guaranteed minimum income
This feature ensures that the annuitant or beneficiaries receive a minimum amount, regardless of the performance of the annuity’s investments. This kind of benefit is typical on variable and indexed annuities, where the accumulated balance depends on the investments’ performance.
Long-term care insurance
Some annuities can be set up with long-term care insurance, though you’ll want to read carefully to understand what the plan covers and what it doesn’t.
What to watch out for with annuities
Annuities can offer a variety of benefits, but they come with a lot of caveats, too. So you’ll want to read any annuity contract carefully to understand what you’re actually agreeing to.
Expenses
The expenses in an annuity contract can be extensive, and every rider you add to an annuity contract increases the overall cost. You’ll have to pay administrative charges and may end up paying mortality and risk expense charges, often in the range of 1.25 percent of your account value annually, according to the Securities and Exchange Commission.
So you need to understand the full range of expenses that you’re paying and may continue to pay over time. They can really eat into your returns.
Investment fees
If you’re opting for a variable annuity, you’ll end up paying a variety of fees for the investments themselves. Those fees could be substantially more than the fees you’d pay in comparable — and perhaps better-performing — publicly traded investments.
Cancellation period and penalties
When you sign an annuity contract, you’re often locking your money up for a long period of time. Typically, you have some period where you can cancel the contract, but it may entail substantial fees called “surrender charges.” These fees are effectively sales commissions that go to the firm selling the annuity.
Bottom line
Annuities can be an effective solution for the right kind of customer, helping them achieve cash flow that can support them in their retirement years without worrying about running out of cash. For others, however, the costs and general inflexibility of annuities might outweigh the benefits.
“Take your time when shopping for an annuity,” says de la Rosa. “Consult with an advisor who is not beholden to one carrier. Consult with an advisor who has your best interests at heart and not a commission.”
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