Types of Annuities
Annuities are a popular investment to establish retirement income.
There are a variety of different types of annuity. However, because there are so many different types of annuities, each with their own set of rules and regulations, it is important to educate yourself on investing in an annuity. The following is a general overview of the most commonly purchased annuity products. Remember, although general distinctions can be made between the different types of annuities, the specific annuity product you purchase may differ depending on the company you purchase from, and it is important to discuss the details of any contract with your financial planner. The advantages and disadvantages of each type of annuity are relative to the customer's, or annuitants, circumstances and needs. Reviewing characteristics of the different types can help you gauge what best fits your situation.
Single-Premium immediate Annuity (SPIA)
A Single Premium Immediate Annuity is a type of annuity that delivers payments that begin right away and continue for a specified amount of time, often for the rest of your life. The annuity is purchased with a one-time payment, called a premium. In exchange for your premium, the insurance company makes regular payments to you for the chosen length of time, often the rest of your life. With a SPIA, you have the choice to select the mode of payments, or frequency of payments, whether it is monthly, quarterly, semi-annually, or annually.
Single-premium immediate annuities offer several options that can be customized to fit your circumstance and financial needs. In exchange for the guarantee of payments, you give up the right to demand the return of your original premium. Unlike some forms of life insurance or other types of annuities, you are generally unable to revise or cash in the immediate annuity.
Benefits and drawbacks
The most obvious advantage of a SPIA is that it offers a secure, steady stream of income. This aspect of SPIAs makes them a very popular choice for individuals that want to ensure they do not outlive their savings. By investing in a Lifetime immediate annuity, you ensure that you will continuously receive payments.
Single Premium Immediate Annuities offer a no-risk investment of your principal. Because you are guaranteed to receive payments regardless of market fluctuations, there is no need to be concerned with variable interest rates or other issues with the market.
Another important aspect of a SPIA is that they often offer better interest rates than other no-risk investment options, such as CDs.
Immediate annuities also offer tax deferment for qualified funds, which allow you to postpone paying income taxes on your investment until later in retirement when your income tax rate may be lower.
Like with other annuities, SPIAs take control of your money and put it in the hands of the seller. Once you have entered the annuity contract, you do not have a way of demanding the return of your premium without large penalties.
One potential drawback of the SPIA is that oftentimes, without an additional Rider which will increase costs and/or reduce your payments, you will not be able to leave any of the annuity to your beneficiaries after you pass away. For example, if you buy a SPIA today with the expectation that it will pay you for the coming 20 years, but you unexpectedly pass away in the next few years before your premium is returned to you, these funds will not be passed on to your beneficiary.
Fixed Indexed Annuities (FIA)
In today’s retirement marketplace, fixed indexed annuities have become an increasingly popular option for retirement planning. Fixed indexed annuities are an alternative to single-premium immediate annuities, and they differ from immediate annuities in a few key ways. Primarily, while an immediate annuity begins paying you immediately after purchase, fixed indexed annuities are deferred annuities. This means that there is a designated period of time between the payment of your premium and the beginning of your annuity payments. This period of time is referred to as the accumulation phase. During the accumulation phase, your money is allowed to grow, tax deferred.
One aspect of fixed index annuities that make them particularly attractive to buyers is that they offer the opportunity for potential interest growth based on changes in one or more indexes, such as the Standard and Poor’s 500 index. However, fixed index annuities also guarantee a minimum interest rate, therefore protecting you from potentially negative changes in your target index. The advantage of this annuity is that it offers some of the potential gains of market changes, while making it a low risk investment by guaranteeing a minimum interest rate. Furthermore, because the interest that your FIA contract earns is tax deferred, your asset can accumulate much faster.
Benefits and drawbacks
Tax deferral is the most obvious benefit of a fixed index annuity. Tax deferred growth, compounding over time, allows your asset to grow quicker than it would otherwise. While FIAs are not the only asset that allow tax deferred growth, other options such as IRAs and 401(k)s have contribution limitations that cap the amount of money you can invest tax deferred.
Another advantage of the fixed index annuity is that it offers growth based on an external index. In fact, some annuity options allow you to choose multiple indexes with a portion of your annuity targeting each index. Of course, you do not have to assume the risk of negative fluctuations in the index, instead you will simply not receive interest for that time period; your annuity does not lose value.
Deferred fixed index annuities often have a provision such that a death benefit will be paid to your beneficiary if you pass away before you begin to receive annuity payments.
Although FIAs seem to offer growth and low-risk, some financial advisers criticize them as a poor investment. The biggest complaint about FIAs is that their performance does not directly match the index’s performance and does not include dividends. Some suggest that comparable market investments can produce better growth when accounting for dividends.
One criticism of annuities in general is that they carry with them high costs and fees relative to other investment opportunities. Furthermore, there are stiff surrender penalties for early withdrawal, plus a premature distribution penalty for withdrawals taking place prior to the age of 59 and a half.
Another one of the biggest complaints about FIAs is that even though you are enjoying the benefits of tax deferred growth, once you begin taking payments from your annuity, those gains are taxed as ordinary income, as opposed to capital gains.
A variable annuity is unlike other annuity products in that it comes with more risk to your investment. Variable annuities are similar in some ways to investing in a mutual fund because their performance is tied to mutual fund like sub-accounts and can benefit from gains in the market. Variable annuities differ from mutual funds in a few key ways: earnings receive tax deferment, there is typically a death benefit, and annuity payments exist as an option to provide a sustained income stream.
A variable annuity's rate of return is not stable, but changes depending on the performance of the stock, bond, or money market sub-account that you select for your annuity to be invested in. Unlike other annuity choices, variable annuities offer no guarantee that your investment will earn any return, and there is some risk that you will lose part of your investment. Variable annuities are regulated as securities registered with the Securities and Exchange Commission (SEC).
Benefits and drawbacks
One unique advantage to variable annuities is that you have a greater amount of power over where you want the money in your annuity invested, and therefore you have some control over its performance. Moreover, often you have the power to move money between your annuitiy sub-accounts. Tax deferral is the most obvious benefit of a fixed index annuity. Tax deferred growth, compounding over time, allows your asset to grow quicker than it would otherwise. While FIAs are not the only asset that allow tax deferred growth, other options such as IRAs and 401(k)s have contribution limitations that cap the amount of money you can invest tax deferred.
Like other annuity products, variable annuities have the advantage of offering tax deferred growth. Unlike 401(k)s and IRAs, there is no limit to the amount of money that can be invested in annuities that can still enjoy tax benefits.
The most obvious disadvantage to variable annuities is that there is not guaranteed growth for your investment, and there is even a risk of losing on your investment.
Deferred variable annuities should be considered long-term investments. Terminating the contract prematurely can cause you to take a loss on your initial investment. Many variable annuities impose surrender charges for withdrawals made during a specified period of time, which are often as long as six to eight years.
Another common complaint regarding variable annuities is that they include several different types of fees. Sales and surrender fees, administrative fees, mortality and expense risk charges, and underlying fund expenses related to your sub-accounts are all fees that you may encounter with a variable annuity.
Deferred Income Annuities (DIA)
A deferred income annuity, sometimes called a longevity annuity, is a newer type of annuity that is essentially a cross between a single premium immediate annuity and a single-premium deferred annuity. As this is a deferred annuity, you must allow a specified period of time to pass before you receive payments. Like the immediate annuity, your monthly payout is fixed for life. Deferred income annuities are structured such that the longer you wait to begin receiving payments, the higher your payments will be.
Unlike the fixed index annuity and the variable deferred annuity, the deferred income annuity is designed to provide you with a stream of income during your retirement and not as a vehicle for principal growth. However, unlike the single-premium immediate annuity, the deferred income annuity is more appropriate for those that have the ability to wait before they begin receiving payments. In fact, the DIA is designed to reward those that can wait longer to begin receiving payments. Most deferred income annuities allow you to make additional contributions, but the way they are factored into your payments depends on your specific annuity contract.
Benefits and drawbacks
One advantage of the DIA is that it offers higher payouts than single-premium immediate annuities. This is due to the deferred period in which you are not receiving payments.
Like with other annuity products, the DIA offers a lifetime of income payments that can be used to supplement other retirement income.
Unlike some other products, the DIA is not a liquid investment. This means that once you have made your purchase, you forfeit the premium payment in exchange for the agreed upon annuity payments.
Another common criticism of the deferred income annuity is that it is rarely adjusted for inflation. This basically means that even though you have a guaranteed income stream paying out a specified dollar amount, as years go by, this amount may have a significantly reduced purchasing power.