The large number of annuity products on the market today can make understanding them difficult. But in fact, there are only a handful of different types of annuities, and we will help you find the best types to suit your needs. First, let’s discuss the three primary considerations when thinking about annuities:
Timing of payout — immediate or deferred:
The first thing to determine is if you need an immediate or deferred annuity. Read on to learn the difference.
In an immediate annuity, the investor begins to receive payments immediately upon investing. This is for investors that need immediate income from their annuity. When you purchase an immediate annuity you can choose between payments for a certain period of time (typically five to twenty years – “period certain”), payments for the rest of your life and/or your spouse’s life, or any combination of the two. You can even choose between a fixed payment that doesn’t vary or a variable payment that is based on market performance.
In a deferred annuity, you typically receive payments starting at some future date, usually at retirement. However, most deferred annuities allow for systematic withdrawal payments beginning thirty days after the purchase of your annuity, up to 10% per year, in most cases. With a deferred annuity you can invest either a lump sum all at once, or make periodic payments, either fixed or variable. Those funds grow tax-deferred until you’re ready to begin receiving payments. Deferred annuities make up a large majority of all annuity sales in the United States, and are the type of annuity that Annuity FYI generally recommends if you do not need immediate income from your annuity.
Investment type — fixed or variable:
The next decision to make is the investment type best suited to your needs: fixed or variable.
Fixed annuities are invested primarily in government securities and high-grade corporate bonds. They offer a guaranteed rate of return, typically over a period of one to fifteen years. There are two basic types of fixed annuities: the Guaranteed Return Annuities (GRA) is a fixed annuity that offers a guarantee that you can never receive less than 100% of your investment — no penalties or fluctuations in the interest rate market can impact your principal should you surrender. The Market Value Adjustment annuity (MVA) works much like the GRA, but there is no guarantee of your principal if rates rise and you surrender your contract. MVAs work like a bond and often pay more than a GRA due to the increased short-term risk of rising rates. It is important to note that, unlike a variable annuity, where your funds are held separately from the insurance company, with a fixed annuity your assets are part of the general accounts of the insurer, and are subject to the claims-paying ability of the issuing company. For this reason it is important to understand the financial strength of the issuing insurance company before you buy a fixed annuity. See our section on financial strength ratings for more information.
A variable annuity is a contract between you and an issuer whereby you agree to give the issuer principal and in return the issuer guarantees you variable payments over time. While annuities are not insurance policies, they are issued by insurance companies. Variable annuities are different than their fixed annuity cousins, which are invested primarily in government securities and high-grade corporate bonds, and offer exclusively a guaranteed rate, typically over a period of one to ten years.
There are several distinctive features of variable annuities:
Invest Unlimited Funds, Tax-Deferred
A variable annuity is similar to a retirement plan in that you can fund it in a lump sum or a little at a time, and all capital in an annuity grows and compounds tax-deferred until you begin making withdrawals. Unlike retirement plans, however, there is no limit as to how much you can invest in annuities! With a variable annuity you can invest unlimited funds, tax deferred (unlike IRA, 401ks, and other retirement vehicles, which have annual maximum contributions). Variable annuities can grow tax deferred until withdrawn.
Wide Variety of Investment Options to Permit Stock Market Gains
Variable annuities enable you to invest in a selection of portfolios, called sub-accounts. These sub-accounts are tied to market performance, and often have a corresponding managed investment after which they are modeled. Available choices range from the most conservative, such as money market, guaranteed fixed accounts, and government bond funds, to more aggressive such as growth, small cap, mid cap, large cap, capital appreciation, aggressive growth, and emerging markets investments. You can invest in fixed accounts, money market, domestic, international, specialty, sector funds and small, medium and large cap funds. Some have as many as forty or more investment choices with ten or more managers, and allow you to switch between them at no cost and without taxes (although excessive changes to your contract could result in the imposition of a small fee, so be sure to consult your financial planner or prospectus if you are making regular changes). Variable annuities typically allow a wide variety of investment options including . Many variable annuities allow for transferring among sub-accounts free of charge.
Unlike mutual funds, variable annuity products come with optional living benefits and death benefits. One special type of variable annuity benefit is the GMIB (Guaranteed Minimum Income Benefit). The most competitive GMIBs guarantee at least a 5% return over seven years, or the highest attained value on each anniversary during the surrender period, whichever is greater. In exchange for this living guarantee, the living benefit annuity has a surrender charge / penalty for early withdrawal (typically 7 years), no up-front bonus, and a slightly higher annual fee (.25% to .50% per year). Lifetime Income Benefit annuities are also very popular. The concept behind a Lifetime Income Benefit is simple. If you purchase a Lifetime Income Benefit Rider with your variable annuity, the insurance company guarantees a regular monthly, quarterly, or annual payment for your lifetime, even if your account balance goes to zero — income you can never outlive.
Another important feature of some annuities is the death benefit provision. The annuity issuer guarantees at a minimum that upon your death your total premiums invested are paid to your beneficiaries. Many annuities “step-up” on the anniversary of the date the annuity was purchased, to the highest value at any preceding anniversary; or guarantee a minimum 5% to 7% interest compounded annually, whichever is greater. Some variable annuities now even offer a combination of the aforementioned benefits, i.e. the greater of 5% or 7% compounded annually, the highest contract anniversary or the actual account value on death to the heirs (see death benefits under compare annuities for more detailed information). For example, assume you invest $10,000 in a variable annuity with an annual step-up, and over the next several years your contract grows to $40,000 on its anniversary. Now assume that the market goes down and your value drops to $25,000, and just as you thought things couldn’t get any worse , you die. In this hypothetical scenario your heirs would receive the the highest contract anniversary of $40,000. The enhanced death benefit options offered by insurance companies come at an additional expense, typically ranging from 0.05% to 0.50% on top of the regular annual expenses. Furthermore unlike a death benefit from a life insurance policy, the death benefit associated with an annuity does not transfer to the beneficiaries income tax free. That said, you don’t have to qualify for the annuity death benefit either.
Finally, you will need to determine which liquidity option best suits your needs: those with or without withdrawal penalties.
Annuities with Withdrawal Penalties
“No-surrender” annuities allow you to withdraw either your interest earnings or up to 15% per year without a penalty (although any withdrawal from an annuity may be subject to taxes and a 10% federal penalty if taken prior to 59? years of age). Beyond that, most annuities have a surrender charge — a penalty for making an early withdrawal above the free withdrawal amount. Typically this surrender charge decreases over a seven-year period.
Why would you choose an annuity with a withdrawal penalty? Well, some annuities with surrender charges reward the investor by offering a “bonus”: the insurance company adds on average 3% to 5% to the amount of your principal. For example, if you invest $10,000 in a bonus annuity the insurance company will add $300 to $500 to your annuity immediately. The trade-off is that with a bonus annuity the surrender period is usually longer (eight to nine years in most cases versus the typical seven-year surrender). Be aware, some insurance companies charge higher fees on their bonus annuities, as compared with their standard products. Be certain to compare the annual fees of a bonus annuity to the standard or traditional (no-bonus with 7 years of surrender) annuity. Sometimes the life insurance company will raise their fees to pay for the bonus.
Annuities without Withdrawal Penalties
For investors who may need spur-the-moment access to their money, there are annuities without surrender charges (no-surrender or level load annuities) — these annuities have no penalty or charge for early withdrawal. (That said, even with a no-surrender annuity investors under the age of 59 ? are subject to a 10% federal excise tax as well as ordinary income taxes on any gains. You can avoid any taxes or penalties, however, by making a 1035 Tax-Free Exchange to another annuity, regardless of age.) No-surrender annuities do not come with bonuses, and some insurance companies charge higher fees for their no-surrender charge products, so be sure to compare all fees before you invest.
Most companies now offer no-surrender annuities. However, if you are asking a local broker or agent for their recommendation they may not share with you the no-surrender annuity, as these annuities pay the broker a much lower fee. Some agents will even try to steer the investor to annuities with surrender charges but without bonuses.
Annuity FYI can help determine which annuity is most suitable for you. For more detailed information, visit our Compare Annuities section, or Click here to contact an Annuity FYI expert.