Types of annuities

What is an annuity and how does it work?

An annuity is a contract between an insurance company and an individual. The individual agrees to make contributions in the form of ongoing payments or a lump sum and, in exchange, the insurance company agrees to provide a guaranteed stream of income to the individual at some point in the future for a specified period of time or until their death. Annuities allow contributed funds to grow tax-deferred. In addition, the fact that annuities offer a guaranteed stream of income can make them a good option when planning for retirement income.

Annuity types

There are four primary types of annuities: fixed, variable, immediate and deferred. The chart outlines each of the different types for easy comparison.

Fixed annuities

A fixed annuity provides a guaranteed rate of interest once contributions have been made. This is a great option for those who may be risk averse and want to know that a fixed income stream will be available to them at some point in the future. Fixed annuities offer a high level of security, however interest rates are generally lower than those paid on other types of annuities like variable or indexed. If inflation rises, the distribution payments lose real value over time due to their fixed nature.

Variable annuities

Variable annuities are variable in that the underlying value and distribution payments are based on the performance of the underlying investments, which are chosen by the annuity holder. This type of annuity may be a better choice for a more seasoned investor who is comfortable with higher risk in exchange for earning potentially greater returns.

Immediate vs deferred annuities

Immediate and deferred annuities differ regarding when payout begins. With an immediate annuity, payments begin shortly after the contribution is made, typically within a year. Deferred annuities, on the other hand, are designed to allow contributions to grow over a longer period of time before payments begin. Deferred annuities are designed for long-term growth and future income. Here are a few key considerations when choosing between an immediate annuity and a deferred annuity:

• Someone who is close to retirement age and needs immediate income may wish to invest in an immediate annuity
• Someone who is seeking to set money aside for tax-deferred growth may opt for a deferred annuity
• By making regular contributions over time, a deferred annuity can be invested in options that may yield a greater return

How to choose an annuity

Your decision should be made in light of your specific financial situation, retirement goals and income needs. Here are some things you may want to consider:

• Do you have specific income gaps that are left after you consider other sources of retirement income such as Social Security or a pension?
• How much have you saved for retirement and do you think you might outlive your savings? This may be a clue that you should consider an annuity that pays out until death.
• How far are you from retirement age? Do you need an income stream immediately or years down the road?
• Is it more important to you that you receive a guaranteed payout or that your return on your money is maximized?
• Are you concerned that inflation will result in an inability to live comfortably in retirement? If so, a variable annuity may be a better choice for you.

In addition to choosing the type of annuity that best meets your needs, it’s also important to carefully choose the company issuing the annuity. Here are some suggestions to help guide that process:

An annuity is a long-term agreement between you and the insurer. Before you settle on an annuity, check the life insurance company’s financial rating to ensure that they’ll be around for the long-haul. Similar to consumer credit bureaus, there are several insurance rating agencies such as A.M. Best, Moody's, Fitch Ratings and Standard & Poor’s that can provide you with an indication of an insurance company's financial stability. Note: Not all companies are rated by all the agencies, and they each have unique standards and rating methods. Be sure to review more than one agency’s rating before making a decision.

2. Check with your State Guaranty Association
All insurance companies licensed to sell life, health or annuities in a state must be members of the state’s guaranty association. This provides a safety net for the funds from your annuity – up to the state’s maximum amount – in the event the insurer is unable to pay the benefits in full. However, it’s a good idea to understand just how much of your annuity contract your state’s fund would cover, including any dollar limits that may apply.

3. Shop and compare
When it comes to annuities, you have many options from which to choose. The right annuity for you is the one that meets your personal and financial objectives.

Pros and cons of annuities

As with every financial investment tool, annuities have their pros and cons. Annuities may be a good choice if you think you might outlast your retirement savings and want to ensure a stream of income for a certain period of time or until your death. However, fixed annuities may not provide the highest return compared with other investment options. If inflation surges, the interest payments associated with a fixed annuity may not cover expenses as you had planned. Variable annuities can offer a higher return based on the performance of the market, but annuities can be subject to fees and expenses.

Unlike 401(k)s and IRAs, annuities have no contribution limits so if you’re seeking a way to set aside money for tax-deferred growth, an annuity may be a good option for you. However, annuities don’t offer a lot of flexibility to access your money prior to the agreed-upon payout period. You will likely pay penalties and fees for early withdrawal.

Frequently asked questions about annuities

What are the main types of annuities?

There are fixed and variable annuities, which describe the payout. Fixed annuities offer payments based on a guaranteed rate of interest. Variable annuities offer payments based on the value of the underlying investment, which fluctuates with the market. Immediate and deferred annuities refer to the timing of the payout and can consist of either fixed or deferred annuities.

How are immediate and deferred annuities different?

Immediate annuities typically begin payout within a year after investment in the annuity. Deferred annuities begin payout after a longer period of time to give the contributions time to grow.

Are annuities a good investment for retirement?

There is no “ideal” retirement strategy. Annuities can be a helpful component of a retirement strategy depending on your financial goals, resources, level of risk-adversity and particular needs. It may be a good idea to consult with a financial professional to discuss how annuities may fit into your retirement strategy.

Can I lose my money in an annuity?

With variable annuities, it is possible to lose the annuity’s value based on market fluctuations. Your annuity value may also lose money based on fees and early withdrawal penalties. However, it may be possible to purchase riders with an annuity to offer guaranteed return of your original investment at the time of your death. Check with your financial professional or the insurance company to clearly understand the provisions of the contract.

Getting the help you need

If you’re feeling unsure about making an annuity selection on your own or if you need more information and personal guidance, speak with a qualified financial professional or life insurance representative.

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