A common misconception about annuities is that they all offer the same benefits, but there's no such thing as a standard annuity agreement. Instead, there are a few broad types of annuities, each providing different levels of growth, risk, and protection.
Read on to review common examples of annuities and weigh their pros and cons against your goals.
Annuities are contracts between you and an insurance company. You pay them either a lump sum or multiple payments, and in return the insurance company pays out a fixed or variable income stream to the purchaser beginning right away or at some point in the future in exchange for premiums you’ve paid.
Annuities can help you reach your financial and life goals. They often offer fixed returns or guarantees, protecting against market fluctuations. Additionally, annuities can be structured to pass on benefits to heirs, ensuring financial security for loved ones. And the money in an annuity can grow either tax-deferred or not, making for tax-advantageous growth for your savings.
A significant appeal of annuities is that they offer guaranteed growth, principle protection, and predictable payouts, but how you access these funds — and how they grow — depends on your annuitie’s structure. You can also modify annuities with additional benefits, called annuity riders, that offer customization to fit your needs.
The main differences between annuities are when payouts occur (immediate or deferred) and whether for the annuity offers guaranteed growth or is subject to market fluctuation. We’ll cover these distinctions below and offer examples to help you find the best annuity for your needs.
If you’re looking to get a guaranteed, fixed rate of return, fixed annuities are an excellent choice. These straightforward annuities promise a guaranteed interest rate from the start, so there's no question about how much you'll earn. The tradeoff? You can't take advantage of market growth.
For example, a fixed annuity might offer a 5.5% annual percentage yield (APY) over a 10-year term. If you invest $100,000 in this fixed annuity, you'll receive $5,500 in the first year. Your annuity’s total will reach $105,500, so you’ll earn $5,802.50 the next year. This is known as compounding returns, and your account value will continue to grow annually following the same trend.
If you're looking to get potential growth based on market returns, variable annuities might be the right fit. With this higher-risk annuity, you'll ride the waves of the stock market in a tax-deferred account. But these annuities don’t come with downside protection, so there’s no guarantee you’ll see any gains.
Rather than getting fixed growth, your returns will vary based on how well your subaccounts perform. Subaccounts are separate investment options offered within a variable annuity. They track the performance of specific assets, such as mutual funds, and in some cases, you can choose which asset you’d like your annuity to be linked to. When the market does well, so do your account value — but your account value can shrink (even going to 0) if your subaccounts do not perform well.
Suppose you invest $50,000 into a variable annuity and select one subaccount for your deposit. If the subaccount grows by 10%, your account value can grow by the same amount to $55,000, depending on the terms of your contract. However, if your subaccount decreases by 10% so will the funds allocated to that subaccount.
This annuity may be the right choice if you have a large sum of money in savings. While you could manage these funds in a personal account, another option is to convert it to an immediate annuity. In this contract, you deposit the lump sum in the annuity as your purchase payment, and the insurance company immediately converts it to monthly, quarterly, or yearly payouts. Because these payments are scheduled, it takes the stress out of managing such a large pool of funds.
Suppose you receive a $50,000 inheritance from your father. You buy an immediate annuity to secure a steady income of $250 per month starting one month after the purchase date. These $250 payouts are fixed and last for the rest of your life.
Deferral in deferred annuities has dual significance. First, this annuity matures later, typically years after purchase. Rather than converting money into payouts shortly after purchase, you have to wait to receive your first payout, and there are steep penalties (known as surrender charges) for requesting funds earlier.
The second meaning highlights this plan’s tax implications. Deferred annuities are tax-deferred, meaning you won't pay taxes on your initial investment or contributions. Instead, you pay taxes on your annuity's earnings once you make withdrawals.
Suppose you buy a 10-year fixed deferred annuity for $100,000 with a 4% APY. In this agreement, you either make regular payments to hit your $100,000 target during the accumulation period or deposit a lump sum and wait 10 years. You don't have to pay taxes on yearly compounded earnings. Only after you start taking withdrawals will you add the annuity's payouts to your income tax statement.
Unlike a fixed annuity, the growth of your account value in a fixed index annuity is linked to a financial index, such as the S&P 500. This allows your account value to earn interest credits that are linked to the performance of a financial index. If the index goes up, so will the interest credited to your account value.
But don't worry if the index performs poorly. The fixed part of this annuity guarantees you a minimum return, even if the index return the annuity is tracking is negative. Say you deposit $100,000 in a fixed index annuity linked to the S&P 500. With this annuity, you can earn up to 20% but no less than 1%. If the S&P 500 grows 25% in the first year, your account will grow 20%, or $120,000.
If you’re unsure which annuity type best suits your portfolio, review a few preliminary steps so you can feel confident about your investment decision.
Annuities are long-term investment vehicles, but you have flexibility when setting your risk profile and first payout date. Those who prefer certainty in returns (with limited upside exposure) may generally want to stick with fixed annuities to lock in returns and eliminate market volatility. Investors comfortable with volatility can choose variable annuities for higher potential gains, but are ok with the risk of loss of their investment or fixed indexed annuities for a mix of growth and guaranteed returns.
Another consideration is when you want your principal converted into withdrawals. Deferred annuities offer better growth for annuitants willing to wait, but you must feel comfortable freezing funds for years. Typically, those at or near retirement age are more interested in immediate annuities, and those with a longer investment timeline use deferred annuities' delay for compounding gains.
When you clearly understand your goals and preferences, research the latest rates and fees in the annuity market. For fixed annuities, focus on the available interest payouts versus the latest federal funds rate to gauge the industry average.
With variable or fixed indexed annuities, look at the historical performance of the annuity's underlying investments and compare across different providers. While past performance can't predict the future, it gives a point of reference to figure out the expected risks and returns for different subaccounts.
It's tempting to dump a lump sum in an annuity promising above-average returns, but first, you should screen each insurance company's reputation. Since annuities are long-term contracts, choose a provider with a proven track record of complying with legislation and meeting their obligations.
Check financial ratings with independent agencies like AM Best, and visit review websites like Trustpilot for an annuity company's trustworthiness score. Also, consider calling an annuity provider's customer care team to test their responsiveness and ask questions about different product offerings.
