Banking 101: What Are the Different Types of Annuities?

Annuities can be a great tool for retirement, but they can also be expensive and confusing to understand. Do you know the different types of annuities?

Generally, your main options are fixed, variable or indexed annuities. Breaking it down further, immediate annuities can provide a stream of income within a year or so, while deferred annuities benefit you at a later date.

Here’s a deeper look at the different types of annuities so that you know your options.

What is a fixed annuity?

Just as the name suggests, a fixed annuity allows you to receive a fixed amount of income in retirement — similar to receiving a pension.

Annuities are insurance contracts that are paid out by insurance companies who invest your money for you. To provide a steady, reliable stream of income, fixed annuity funds are typically invested in corporate and government bonds, which don’t fluctuate as much as stocks.

Generally, fixed annuities pay you the same amount as long as you live, though it’s possible to be paid for a set period, such as 25 years. Fixed annuities are typically paid for via a lump sum.

Payments can cover both you and your spouse. This way, if you die before your spouse, they can still receive payments.

What sort of saver needs a fixed annuity?

Ian Bloom, a certified financial planner with Open World Financial Life Planning, suggests fixed annuities to clients under two scenarios.

The first is if a client is worried about the ups and downs of the stock market and wants to make sure their bills are still paid. “Managing their fixed household expenses … can be a good way to help them with this fear,” Bloom said.

The second is for clients who acknowledge they have bad spending habits but won’t fix them. This way, you convert assets that can be spent too fast into a fixed income that cannot.

Fixed annuity advantages

• Fixed payout
• Simple and predictable
• Taxes deferred on earnings
• Lower investment minimums

Fixed annuity disadvantages

• Requires lump-sum payment
• Limited protection against inflation
• May have high surrender or withdrawal charges — for example, up to 7% — for cashing out early

What is a variable annuity?

A variable annuity, on the other hand, is invested just like your regular retirement accounts.

You make regular payments and can choose the investments according to a preset list of choices (these are typically mutual funds that invest in stocks, bonds and money markets). The value can go up or down accordingly — hence the name variable.

You’re in the accumulation phase as you make payments. Various fees may be taken out of your payments, so the total that ends up in your account could be less. You’re in the payout phase when you start to receive funds.

What sort of saver needs a variable annuity?

“Variable annuities are most useful for high-income earners who have already maxed their retirement plans but need to save more to maintain lifestyle in retirement,” Bloom said.

In other words, they’re not so great for paying your rent during retirement. But if you need to save more money in a tax-advantaged way (for example, by paying taxes when you receive the income, when your tax bracket is theoretically lower), a variable annuity might just be the ticket. Be careful not to withdraw money until you’re at least 59 ½. Just like with many retirement accounts, you may have to pay an IRS-imposed 10% penalty for withdrawing the money early.

Variable annuity advantages

• Taxes deferred on earnings
• Can choose your investments
• Can use “1035 exchange” to convert your variable annuity to another type of annuity or life insurance contract to avoid paying taxes for even longer

Variable annuity disadvantages

• Expensive
• Could lose money on your investment
• May have high surrender or withdrawal charges for cashing out early

What is an indexed annuity?

An indexed annuity is also known as an equity-indexed annuity, or EIA, because its value is typically tied to an index such as the S&P 500.

This is the most complex of the annuities because it represents a sort of hybrid between fixed and variable.

That’s because an indexed annuity typically offers a set minimum return, with the possibility to earn more money if the index it’s linked to goes up — usually to a preset cap. However, to manage that protection and the possibility for more earnings, you’ll pay more overall for an indexed annuity.

What sort of saver needs an indexed annuity?

Bloom said he doesn’t recommend indexed annuities. “Eating into market returns to secure ‘downside protection’ (usually the large selling point of indexed contracts) is inefficient,” he said.

He added: “Time and planning are a better solution for most folks than indexed contracts.”

Indexed annuity advantages

• Taxes deferred on earnings
• Offers minimum return, similar to fixed annuities
• Offers possibility of greater returns if markets rise

Indexed annuity disadvantages

• Expensive
• Very complex to understand
• Returns usually capped at a preset percentage
• May have high surrender or withdrawal charges for cashing out early
• Difficult to comparison shop different indexed annuities

Fixed annuity vs. variable annuity vs. indexed annuity

Deferred annuity vs. immediate annuity

All three types of annuities — fixed, variable and indexed — can be put into another box, depending on when they pay out.

An immediate annuity can start paying out within a year after a lump sum is converted into an annuity. This is often the case if a retiree wants to convert part of their existing retirement savings into a guaranteed income stream.

A deferred annuity is paid over several years in smaller payments, much like how you would save up for your retirement normally. This allows you to save money in an annuity while you’re still in the workforce. You can defer payment on an annuity anywhere from 13 months to 40 years, depending on the annuity you purchase.

Given that there are no after-tax limits on how much money you can put into an annuity, this can be a great way to boost your retirement savings if you’re already maxing out your accounts.

The bottom line on different annuities

Commissions on annuities can be steep — from 1% to 10% of the total value — so the chances that you’ll find yourself in a high-pressure sales pitch at some point in your life are good. It’s important to remember that annuities are complex financial tools, some more so than others.

It’s possible that annuities are right for you, but it’s not something you want to jump into right away. Meet with a fee-only advisor who can help you objectively assess whether an annuity fits into your long-term plan and — if so — which type of annuity would be best and for what price.

That way, you’ll be in full control over your financial destiny.