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The Five Annuities You’ll Meet on the Way to Retirement

A few weeks ago a very prestigious financial magazine published a highly misleading article about annuities. The article perpetuated one of the most common errors people make when talking about annuities. And that error is to think that there is one kind of product called an annuity, with minor variations. Not true.

There are at least five kinds of financial products that are all called annuities but that don’t have much else in common. They are called annuities because they are all issued by insurance companies, can all be converted into guaranteed income streams, and all allow the investments inside of them to grow tax-deferred.

But they have different purposes and answer different financial needs. Let’s just walk through them quickly. In future blogposts, I’ll have ample opportunities to go into greater depth.

First, there’s a simple fixed deferred annuity. It’s for earning interest on money that you won’t need for a least a year. The issuers of fixed deferred annuities sometimes pay a higher rate of interest than do money market funds or bank certificates of deposits.  To capture those higher rates, and to postpone taxes on the gains, people invest in fixed deferred annuities.

Then there are fixed indexed annuities. These are a type of “structured product.” That is, when you buy one, most of your money goes into bonds, but some of it goes into options on the S&P 500 or some other stock index. Because of the bond investments, you can’t lose money (except the fees you pay). Because of the stock options, you can potentially earn more than you would by investing only in bonds. When people are dissatisfied with current bond returns but are too nervous to buy stocks, they often buy indexed annuities.

The most popular annuities are variable deferred annuities. These are mutual fund portfolios with insurance features. Those features might include a guarantee that, if you die, your beneficiaries will get at least as much out of the annuity as you put in (even if the market drops in the meantime). They might also include a guarantee that you can withdraw a certain amount of the money every year for life, no matter how long you live and even if your account balance falls to zero. Lots of people buy variable annuities with lifetime income benefits when they’re approaching or in retirement.

Single-premium immediate annuities (SPIAs) are, in a manner of speaking, the only “true” annuities. They provide retirement income. In a sense, they are like life insurance in reverse. With life insurance, you make regular payments to an insurance company and, if you die, your beneficiaries get a lump sum from the carrier. With an annuity, you pay an insurance company a lump sum and, until you die, you receive regular income payments from the carrier. Relatively few people buy SPIAs. When they do, they usually buy them with the condition that, if they die before withdrawing as much money as they put in, their beneficiaries will receive some or all of the difference.

Finally, there are advanced life deferred annuities, or ALDAs. These are for retirees who want to spend freely between the ages of 65 and 85, for instance, rather than have to hoard their savings against the possibility that they will live to 100. They can buy that freedom by putting money at, say, age 65 in a contract that will pay them an income for life, perhaps starting 20 years later. If they die before then, they forfeit the money. ALDAs, like bets on long shots at the racetrack, cost little and can pay off big. But, so far, they haven’t caught on with the public.

So that’s annuities, in a nutshell. Five products, all called annuities, but each with its own rhyme, reason, and potential audience.

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