What Are the Different Types of Annuities?

Annuities can provide guaranteed income for the rest of your life, making them potentially great additions to your retirement plan. But these products can also be complex and have many fees. This is why it's important to understand the different types of annuities and their features before you start shopping.

There are five primary types of annuities: fixed, variable, indexed, immediate and deferred. Read on for more about each type of annuity and how to compare options.

What is an annuity?

An annuity is a contract between you and an insurance company in which you make a payment or series of payments and receive disbursements now or in the future.

These payments can go to you, as the owner of the annuity, or to another person whose age and life expectancy are used to calculate the benefits. The person who receives the payments is known as the annuitant. You can also name a beneficiary who will receive a predetermined death benefit when the annuitant dies, if stipulated in the contract.

Social Security is similar to an annuity, although not exactly the same: You pay into the system throughout your working years and, in return, receive monthly payments until you die. When you purchase an annuity on your own, you may buy a $100,000 contract with a lump sum. The insurance provider then may immediately begin making $500 monthly payments to you that will last for the rest of your life.

Despite potentially providing death benefits for your beneficiaries, an annuity is not life insurance. An annuity’s purpose is to provide a regular income stream during your life, often after retirement.

What are the types of annuities?

Annuities can take many forms, but the basic types are fixed, variable or indexed based on how earnings are accumulated and paid. They can also be immediate or deferred, which determines when you start receiving annuity payouts.

Fixed annuity

Fixed annuities provide guaranteed fixed-dollar payments over the length of time specified in the contract. Before these payments begin, during what is called the accumulation period, your payments will earn interest based on the rate set in your contract. This rate will not drop below a minimum guaranteed rate.

The benefit of fixed annuities is their predictability. With guaranteed interest rates and payouts, you always know what your money is earning and what you'll later receive. This makes them low risk.

The drawback to fixed annuities is that those payments may not keep up with inflation. You may also be able to get a higher rate of return with other types of annuities.

Variable annuity

With variable annuities, you are provided a number of investment options that you can tailor to your own risk level. You can choose investment options such as stocks, bonds or mutual funds. The payout you receive from a variable annuity depends on how these investments perform during your accumulation period.

Remember that with variable annuities, you bear the investment risk. If the investments you choose do poorly, you may receive lower payouts.

This makes variable annuities riskier than fixed annuities. However, a variable annuity may stand a better chance of keeping up with or outpacing inflation because of its potential for higher returns compared with a fixed annuity.

Indexed annuity

Indexed annuities are like a hybrid between fixed and variable annuities. The returns for an indexed annuity are linked to a market index, such as the S&P 500.

Indexed annuities are among the most complex annuities, and their returns can be the hardest to predict because of their variation.

With indexed annuities, you earn only a portion of the underlying index's returns. For example, your annuity may have a participation rate of 80%. This means your account will be credited for only 80% of the index's return: If the index rises 10%, your annuity earns 8%.

Indexed annuities also often have a rate cap that you won't earn above. For example, if your annuity has a 6% rate cap, you would be credited a 6% return even if the index rose by more.

But indexed annuities can also provide downside protection. Some index-linked annuities include a buffer, a feature that protects against market losses. For example, a 10% buffer would shield you from up to 10% declines. Any declines greater than 10%, however, will reduce your account value.

An indexed annuity can also have a floor that sets the maximum amount you could lose.

Immediate annuity

An immediate annuity allows you to begin receiving payments immediately, or no later than one year after you pay the premium. These payments can last the rest of your life.

Immediate annuities are often purchased with a lump-sum payment so you can promptly turn your premium into a steady income stream. Retirees often use immediate annuities for immediate income.

Deferred annuity

If you don't need income from an annuity right away, you might consider a deferred annuity. Payment from deferred annuities don't begin until some future date, often several years after purchase.

This gives you time to increase your annuity's value during what’s called the accumulation phase, when your premium earns interest and grows. It can then be turned into an income stream when you decide later to annuitize — convert your investment into a series of income payments.

Note that when you earn interest in an annuity, you typically don’t need to report your earnings and pay income tax on them. But you will owe taxes on money withdrawn from an annuity, just as you do with a pretax retirement account, such as a traditional IRA or 401(k).

How much do annuities cost?

Annuity costs can vary widely. The insurer and features you choose will determine what you pay in fees. Some of the annuity fees you may encounter include:

• Administrative fee: This is charged to cover the cost of administrative tasks, including processing new business, maintaining systems and running the insurance company. These are typically 0.3% of the yearly annuity contract.
• Surrender charge: You'll pay this fee if you cancel or cash out your annuity contract early. It can range from 5% to 25% of the amount you withdraw and is typically highest in the early years of your contract.
• Mortality and expense risk charge: This annual fee covers the cost of unexpected events, such as the earlier-than-expected death of the annuity holder. It typically ranges from 0.5% to 1.5% of the annuity's value.
• Rider fees: There is often an extra fee associated with each rider, or additional benefit, you attach to your annuity. The exact fee will vary by rider, but you can expect to pay anywhere from 0.25% to 1% of your account value.
• Investment expense ratios: If you invest in funds within your annuity, you will need to pay these funds' management fees, or expense ratios. These typically average 0.06% to 3% per year.
• Sales commission: A commission may be included in your contract fee to compensate the salesperson who sold you the annuity. This one-time fee can range from 1% to 10% of the contract.

To put these fees into perspective, say you invest $100,000 in an annuity. Here’s how fees and commission can affect your return.

Given the above numbers, if you have only one rider, your annuity fees could range from $1,650 to $5,800 per year. This is in addition to the $1,000 to $10,000 sales commission you'd pay at purchase.

Pros and cons of annuities

How to choose the right annuity

Here are some important questions to ask to help you choose the right annuity:

• How will the annuity fit into your overall financial plan? Annuities can be great sources of guaranteed income, but they may not be right for everyone. If you already have enough stable income sources, a more liquid savings option such as a high-yield savings account, or perhaps a CD if you don’t need the money right away, may be better.
• When do you want payments to begin? You'll have the option to choose an immediate or deferred annuity based on when you want to begin receiving payments.
• How much investment risk are you willing to take? Fixed annuities carry the least risk but may not provide returns that are as high as other options. With variable and indexed annuities, you bear the investment risk but may also earn higher returns.
• How much premium can you afford? You may not be able to access your premium without incurring surrender charges, so check that any money you put into an annuity won’t be needed.
• How much income will you require? Compare all of your income sources, including Social Security payments, pensions and savings, with your anticipated expenses to determine how much you would need from an annuity.
• What features are most important to you? Annuities are customizable through riders. These are amendments you attach to your annuity contract for extra benefits, such as principal guarantees and death benefits for beneficiaries. However, riders often come with additional costs. Take the time to consider what features are most important and how much you’re willing to pay.

Remember not to buy the first contract you’re offered. Shop around and compare your options before you commit.