[VIDEO] Annuity Basics & The 4 Most Common Types of Annuities

I am a firm believer that annuities as a whole can do things no other financial product can do. They bring certainties to an uncertain financial plan and investment portfolio. However, choosing the wrong annuity can turn out to be a huge mistake. With so much confusion surrounding annuities, I decided to put together a video tackling annuity basics and the 4 most common types of annuities in the marketplace today.

As a whole, annuities fall into one of two categories: deferred annuities and immediate annuities. The terms deferred annuity and immediate annuity simply indicate when the distribution (or income) phase of the annuity begins…basically when you plan on taking money out. With a deferred annuity, you make a lump sum, or a series of premium payments to an insurance company, and your money has the potential to earn interest during what is referred to as the accumulation phase. With this type of annuity, you benefit from the power of tax deferral, and any interest earned wouldn’t be realized until it’s withdrawn.

Immediate annuities on the other hand allow you to convert a lump sum of cash into an immediate lifetime income stream. They differ from deferred annuities in that they have no accumulation period. They are typically funded with a single lump-sum payment, rather than through a series of premium payments, and the majority of the time the income payments start within one year after the premium has been received by the insurance company.

Now that we’ve briefly touched on the two main categories of annuities, let’s look at some of the most common types of annuities in the marketplace.

Let’s first examine Fixed Annuities. Fixed annuities aretax deferred savings vehicles that pay investors a fixed interest rate for a specified period of time. They are similar to bank CD’s, but guaranteed by insurance companies rather than by the FDIC. Like CD’s, fixed annuities pay guaranteed rates of interest, and in many cases, higher than bank CD’s. They can offer attractive interest rates for both short-term and long-term accumulation, and these terms typically range from 3 years to 10 years. However, if your liquidity needs are more time-sensitive, short-term CD’s may serve you better.

Earnings on CD’s are taxable in the year the interest is earned, and even if you don’t take the money out, you still receive a 1099 for the interest accrued throughout the year. With fixed annuities, earnings accumulate tax deferred, and are not taxable until they are withdrawn. If you find that don’t need the money when the annuity term expires, you can often roll the money back into another annuity. For investors who want to beat CD rates but don’t want to invest in a market-linked vehicle, this can be a place to park funds in a low-risk, tax-deferred investment.

Next are Fixed Indexed Annuity, or FIAs. Fixed indexed annuities (sometime referred to as equity indexed annuities) are tax deferred growth products which accumulate interest based on the performance of a stock market index, like the S&P 500, rather than a specific fixed interest rate. FIA’s enable you to participate in a market index, and earn interest when the market goes up, while offering principal protection if the market goes down. The index annuity’s growth is subject to rate floors and caps, meaning it cannot exceed or fall below the specified return levels, even if the underlying index fluctuates outside of those set parameters. 

With a fixed indexed annuity, you benefit from guaranteed principal while participating in market gains, without being vulnerable to market declines. Essentially, if the market goes up, you get credited some interest based on an investment strategy. However, when the market goes down, regardless of how much, your principal is protected and your account value stays where it is, minus any rider fees and costs if applicable. There are other optional riders or add-ons that can be purchased with FIA’s based on your future needs and goals, so it’s a good idea to explore these as well. For example, one of the most popular riders offered is what’s referred to as an income rider, which allows you to create a lifetime income stream when needed most.

There are many products of this type available that can be issued by a number of insurance companies, so make sure you understand all the nuances before investing. FIA’s are an excellent asset class to consider as part of an overall diversified portfolio. With many moving parts, these products can be difficult to understand, so I recommend you speak to an insurance agent or financial advisor that specializes in FIA’s to make sure you get the annuity that’s right for your particular situation.

Now let’s look at Variable Annuities, or VAs. Variable annuities are tax deferred investment vehicles which allow owners to make an investment with the insurer and allocate their money according to a menu of mutual funds, often referred to as sub-accounts. The returns from a VA vary within the sub-accounts, and these contract values fluctuate based on the ups and downs of the market. Typically, there is no limit on the amount of money you can invest in such annuities and they don’t typically come with upside caps, or downside floors.

These types of annuities typically come with high annual fees, which should be fully understood before making a purchase. VA fee structures are often complex, and can include management fees, annual fees, administrative fees, charges for special add-on benefits, annual mortality fees, and expense-risk charges. The underlying mutual funds in a VA also generally carry internal fees. It’s probably a good idea to read the prospectus that accompany these products, so you understand the investment choices and fees, and have a solid grasp of exactly how the annuity works. Like FIA’s, VA’s also come with the ability to add additional options and guarantees via riders, based on your long-term objectives.

Lastly, let’s look at Single Premium Immediate Annuities, or SPIAs. Single premium immediate annuities arecontracts with an insurance company which allow you to give the company a lump sum of money in exchange for a guaranteed monthly or yearly income stream, depending on the payout option you select. The income stream begins either immediately or within 12 months, and with an immediate annuity, you can choose how long you want to receive income stream. The most common payout options are life only, life with cash refund and a set period of time like 10 years or 20 years…often referred to as period certain.

Here’s the way I see it, one of the biggest challenges many face in retirement is not having enough predictable monthly income to cover expenses or meet their desired cash flow. When retirement income doesn’t meet our monthly expenses, we typically proceed to draw down other assets that are intended for long-term growth. Annuities that provide lifetime income streams like SPIAs, or FIAs and VAs via income riders, give the contract owner the ability to pensionize a lump sum in order to help cover any potential income gaps as they retire. In my opinion, income annuities are great assets, and one of the best ways to address longevity risk.

When it comes to annuities, you have the flexibility to tailor a plan that meets your individual needs. Ultimately, the appropriateness of annuities is dependent upon your circumstances, financial goals, time horizon, tax situation, and the purpose of the money you are considering placing into an annuity. Know what you want, become educated on the details, and then balance the logical sides of the decision. With a variety of optional payout methods, you have the flexibility to choose a plan that fits your retirement needs.

If you are interested in purchasing an annuity, I highly recommended you look for a competent financial advisor that specializes in annuities. These products have a lot of moving parts and with the myriad of options available, they can be complex. The right advisor should be able to help you navigate the waters and select the correct annuity for your particular situation. If you don’t fully understand the product, or you feel it hasn’t been properly explained to you, my advice would be to hold off.

Any comments regarding safe and secure investments, and guaranteed income streams refer only to fixed insurance products and do not refer, in any way, to securities or investment advisory products. Fixed insurance and annuity product guarantees are subject to the claims-paying ability of the issuing company. NOT FDIC INSURED. NOT BANK GUARANTEE. MAY LOSE VALUE, INCLUDING LOSS OF PRINCIPAL. NOT INSURED BY ANY STATE OR FEDERAL AGENCY.