By Jean Gruss
There are a number of different kinds of annuities on the market. To select the best annuity product for your situation, you'll need to find the right combination of characteristics that will help you accumulate savings for your retirement, ensure you have a steady stream of income for a certain period of time even though you no longer work, or both. Below, we break down some of the basic kinds of annuities as well as the benefits and drawbacks of these products.
Types of Annuities
There are different types of annuities available to individuals. Annuities can be fixed or variable, and they can be immediate or deferred.
With a fixed annuity, the insurance company guarantees the principal and a minimum rate of interest. The growth of the annuity’s value and the payments can be a fixed dollar amount or increase by a certain interest rate or formula. State insurance departments regulate fixed annuities.
In a variable annuity, money is invested in mutual funds that are only available to the insurance company’s annuity investors. The amount you will be paid depends on the funds’ performance, net of expenses. As with any mutual fund selection, be sure to pay close attention to fund management fees, investment performance and risk. State regulators and the Securities and Exchange Commission (SEC) regulate variable annuities.
When insurance companies refer to immediate or deferred annuities, they mean the time when they start paying you. With an immediate annuity, payments begin right away, but with a deferred annuity, payments may be arranged to start much later.
The time period over which an annuity is scheduled to pay also differs. Some pay throughout your lifetime, while others (known as period certain) pay for a set length of time, regardless of how long you live. For example, with a pure lifetime annuity, payments stop when you die, even if you pass away shortly after the payouts begin. There is also an add-on option to guarantee your beneficiaries will continue receiving payments for a certain period after your passing, but this benefit can lower the payments you receive while alive.
Riders, such as a cost of living adjustment or a death benefit, can be added to annuity contracts at an additional cost to further customize them as well.
There are benefits of using annuities in retirement planning, according to the Insurance Information Institute. These include:
- Tax Deferral on Investment Earnings
Capital gains and investment income in annuities aren’t taxable until you begin receiving payments. Better yet, unlike IRAs and 401(k)s, there is no contribution limit for annuities. (But if you hold your annuity within an IRA, these the limits apply.)
- Protection from Creditors
Money in tax-deferred retirement plans is protected from creditors. If you own an immediate annuity, the most that creditors can access are the individual payments. In some states, the income from these annuities also is protected.
- Wide Array of Investment Choices
You can buy a fixed annuity that pays a specific interest rate or choose from stock and bond funds in a variable annuity. Some annuities offer floors that limit the declines you might encounter from funds in a variable annuity.
- Rebalance without Tax Worries
You can sell stock and bond funds inside a variable annuity without incurring any taxes. That’s important since your risk tolerance changes over time as you get older and you rebalance your portfolio more conservatively.
- Longevity Hedge of Lifetime Payments
The insurance company pools your money with many others who may not live as long as the life-expectancy tables forecast. That’s what allows the insurer to continue to pay you even if you live longer than expected.
- Protection for Your Heirs
In exchange for smaller payments, you can guarantee payments continue to your beneficiaries for a certain period even if you die shortly after buying the annuity. Annuity payments that pass to beneficiaries don’t go through probate and aren’t governed by your will.
Disadvantages of Annuities
While there are benefits to purchasing an annuity, there are also some important downsides to take into consideration. These products tend to involve a number of different fees that may not be suitable initially or over the long term.
A broker or salesperson may collect a commission of up to 10% on your purchase. This is a powerful incentive to push annuities over other products, regardless of what is the best option for your financial situation. Direct-sold annuities are an exception, though, since these products are sold by investment companies that do not use insurance agents and therefore do not charge a sales commission.
- Limited Access to Your Money
Many deferred annuities feature a surrender period of a certain number of years. If you decide to withdraw money before this period expires, you will incur surrender fees. However, with some contracts, you can make a withdrawal in the event of an emergency or take out up to 10% annually without incurring these charges. You may also be subject to a 10% premature distribution penalty as well if you make the withdrawal before age 59 ½.
- Ongoing Costs
Products like variable annuities involve annual fees for managing your investment, insurance charges, and additional expenses for any riders you have added. This can become very expensive over the long term and undermine the advantages of the annuity that you were drawn to in the first place.