How to choose among the 5 major annuity types
December 16, 2015 by Andrew Murdoch, CFP
As I wrote in my last article — the initial entry in this series of annuity primers — annuities are relatively complicated, and that partly explains why buyers know surprisingly little about what they own. The bigger reason, though, is that many sellers of annuities focus on consummating a sale, not on spending the time required to make sure customers really know what they are buying.
This second installment focuses on the five major types of annuities. Which one you buy is probably as important as how much money you invest in one. That’s because each caters to people with different goals,strategies and risk tolerances. To be satisfied long-term, you have to match your preferences with product types.
The differences in annuities are analogous to the differences among stocks. If you are primarily interested in capital appreciation potential and willing to take risk, you might buy stocks like Google and Facebook, which do not pay dividends and tend to be relatively volatile. If you want a steadier but less stellar performer, you might buy dividend-paying stocks like utility giant Consolidated Edison or railroad behemoth CSX.
There are five major types of annuities. Some are targeted at people who are very financially conservative. Some are targeted at relatively aggressive investors. Others sit somewhere in-between and/or fit a very specific purpose. Here is the rundown:
Fixed annuities. These are fixed interest investments issued by insurance companies. They pay guaranteed rates of interest, typically higher than bank CDs, and you can defer income or draw income immediately. These are popular among retirees and preretirees who want a no-cost, modest and guaranteed fixed investment.
Variable annuities. These are tax-deferred annuities that allow investors to choose from a basket of subaccounts (mutual funds). Account value is determined by the performance of the subaccounts, and a rider can be purchased to lock in a guaranteed income stream regardless of market performance — a key hedge if subaccounts perform poorly. These are popular among retirees and preretirees who want a shot at capital appreciation in tandem with guaranteed lifetime income.
Fixed-indexed annuities. These are essentially fixed annuities with a variable rate of interest that is added to your contract value if an underlying market index,such as the S&P 500, is positive. They typically offer a guaranteed minimum income benefit, and the chance of upside pegged to a market-based index. A drawback is that upside potential is limited by a so-called participation rate,caps or a spread, and so they never keep pace with a robust market. These appeal to retirees and preretirees who want to conservatively participate in potential market appreciation without fuss and with downside principal protection.
Immediate annuities. These are basically a mirror image of a life insurance policy. Instead of paying regular premiums to an insurer that makes a lump-sum payment upon death, the investor gives the insurer a lump sum in return for regular income payments until death, or for a specified period of time, typically starting one to 12 months after receipt of the investment. Payments are typically higher than other annuities because they include principal, as well as interest, and so they also offer favorable tax treatment. These are popular among retirees and preretirees who need a higher-than-average stream of income and are comfortable sacrificing principal in exchange for the extra money or lifelong income.
Deferred annuities. These delay payments until a future date greater than one year.They enable people to increase their income stream later in life for less money because the insurance company is not on the hook for as long when income payments are deferred. These appeal to people who want guaranteed income in the future, not now, or who want to create a ladder of income over different periods later in life. For example, they may want to work in retirement but know that eventually they will stop working and,at that point (and not before), will need guaranteed income from an annuity.
