Understanding Annuities: A Comprehensive Guide
In 2023, annuity sales in the U.S. were projected to reach a record high of more than $350 billion, up 21% over a record-setting year in 2022, according to insurance trade group LIMRA. Yet, annuities may be less familiar than other common financial products like mutual funds or 401(k)s. Many investors don’t know what an annuity is, or what the basic types of annuities are.
Although annuities may seem to come in a million variations, the five basic types of annuities to know are fixed, variable, indexed, immediate, and deferred. For a quick primer on these types—as well as what annuities are and whether they might fit into your portfolio—read on.
What Is an Annuity?
An annuity is a contract between you and an insurance company that provides payments to you in exchange for a purchase price, or premium. To illustrate, an annuity might work like this: You pay an insurance company $100,000 for an immediate fixed annuity, and the insurance company agrees to issue you monthly payments of $600 for life, starting now.
You can purchase an annuity with a lump sum or make payments over time. You can also choose to receive your annuity payout as a single payment or in regular installments.
Annuities may be invested in mutual funds, stocks, bonds, money markets, or a range of investments. Money invested in an annuity grows on a tax-deferred basis: Investment earnings are untaxed while in your annuity account and taxed upon withdrawal. Annuities may have surrender fees and early withdrawal restrictions that can make your money expensive to access if you need it unexpectedly.
An annuity can help you create a stream of income in retirement—or anytime. Depending on your contract, an annuity can provide regular income for a specified period of time (say, five, 10, or 20 years) or even for life. For retirees who may be worried about running out of money, guaranteed lifetime income may be appealing.
5 Types of Annuities to Know
Most annuities fall into one (or more) of these types: fixed, variable, indexed, immediate, or deferred. Here’s how each one works.
1. Fixed Annuities
A fixed annuity guarantees a minimum rate of interest and fixed payments. Your principal is also typically guaranteed, meaning you won’t lose the money you’ve invested (and negatively affect the payments you receive).
Fixed annuities provide a high level of predictability, though not necessarily the highest potential for growth. If you want to add a baseline monthly income to your retirement plan, a fixed annuity may offer the fewest surprises. On the downside, since payments are fixed, they may not keep up with inflation over time.
2. Variable Annuities
A variable annuity directs your premium payments to investment options that may include stocks, bonds, money market funds, or—often—mutual funds. Your rate of return will vary depending on how well your investments do during the accumulation period, when you’re paying premiums and allowing your money to grow. When you’re ready to enter the payout phase, the insurance company will determine a guaranteed minimum payment based on your principal, returns, and expenses.
Because their returns aren’t 100% predictable, variable annuities can be more complicated to understand. You run the risk of losing money on your investments, which could impact the amount you receive during the payout phase. Then again, if you enjoy a high rate of return, your payout could be larger than expected.
3. Indexed Annuities
Indexed annuities combine some of the features of both fixed and variable annuities. They may guarantee a minimum rate of return combined with a return based on the performance of a market index like the S&P 500. Because they offer both a guaranteed return and a performance-based return, indexed funds have a risk profile that’s somewhere between fixed and variable annuities.
Returns on an indexed annuity may have a floor—an agreement that you won’t sustain a loss beyond a certain level. If you have a floor of 10%, for example, your investment value won’t decrease more than 10% even if the market drops by 18%. Indexed annuities may also have a buffer that reduces the impact of a market drop on your investment value. If you have a buffer of 5% and the index drops 12%, you would only “count” 7% of the loss.
4. Immediate (or Income) Annuity
In addition to the three basic types of annuities—fixed, variable, and indexed—annuities are also divided into two categories based on when they begin to pay out. An immediate annuity—also known as an income annuity or single premium immediate annuity—starts making payments right away. The idea is to create a stable income stream using a single lump-sum premium payment. Payments are often made for life.
5. Deferred Annuity
A deferred annuity has a future start date. Prior to that date, your premium payments and interest accumulate, creating the basis for your future payments.
How to Choose the Right Annuity
To choose the right annuity, you may need to think beyond the basic types. Annuities come in many shapes and forms, with individual terms, costs, and benefits. Here are a few additional things to consider if you’re considering an annuity.
Think About Your Larger Financial Plan
Does your retirement fund consist entirely of individual retirement accounts (IRAs) that may or may not last for the rest of your life? Adding a fixed annuity with lifetime benefits could provide steady, predictable income that makes the unknown seem a little less scary. Do you have a pension or Social Security benefits that already provide reliable income in retirement? A variable annuity with returns that follow the markets could help you hedge against inflation.
Consider Fees and Expenses
Annuities typically have higher fees and expenses than investments like mutual funds. Costs may vary between fixed, variable, and indexed annuities as well. You may pay commissions, including sales fees, mutual fund “loads,” surrender charges, and yearly commissions. Recently, commission-free annuities have been growing in popularity. These may be found online or through financial advisors who specialize in non-commissioned financial products. Look closely at any annuity’s fees and expenses. Compare total costs against other annuities—and against other investments as well.
Check for Special Features and Riders
In addition to choosing between the basic types of annuities, you may have the option to select special features and riders like guaranteed minimum income or long-term care benefits. These personalized provisions can make an annuity more useful, but be mindful of the costs and benefits. You may limit your losses or receive additional money under certain circumstances, but you may also pay more for added benefits you won’t need.
Compare, Compare, Compare
Choosing an annuity requires careful analysis. And, because annuity contracts can be complicated, the devil is often in the details. If you can, compare multiple options to find the best fit for your portfolio and plan. Read every contract carefully, ask questions, and get multiple opinions if you aren’t sure which choice is best.
The Bottom Line
Understanding the basic types of annuities is a first step in evaluating whether a particular annuity is right for you. You’ll also want to consider your larger portfolio and resources, as well as your retirement needs. A financial planner may be able to help if you need help deciding where to put your resources.
If you’re considering an annuity, make sure you understand your contract thoroughly. You may also want to check with your state insurance commission or the Financial Industry Regulatory Authority’s (FINRA) BrokerCheck site to make sure your insurance broker is registered to sell annuities. Rating agencies like Moody’s or A.M. Best may help you learn more about the financial strength of the insurance company, to help ensure your claim to lifetime benefits doesn’t outlive your annuity provider.
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