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Types of Annuities: Which Meets Your Needs?

Types of Annuities: Which Meets Your Needs?

December 11, 2020
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In our last blog, we explained what annuities are and how they work. In this edition, we’re going to continue to peel back the layers of the onion and explore the different types of annuities. Our goal is to help you understand the characteristics of some of the most common types of annuities. This will arm you with the knowledge to decide which type, if any, meets your needs. 

To review our discussion from last time, at its core, an annuity is a deal between the annuitant (purchaser) and the annuity issuer, which is usually an insurance firm. They offer investors a way to invest non-qualified money in a tax-deferred vehicle. However, there are many different types of annuities, and each one has its own nuances that you must understand before you decide to invest in an annuity. Knowing the pros and cons of each will help you determine which meets your needs or if you need one at all. 

If you’re looking for assistance in managing your investments or creating a personalized investment strategy, speak with a CERTIFIED FINANCIAL PLANNER™ professional at Good Life Financial Advisors of NOVA today! 

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Fixed Annuities

A fixed annuity provides a fixed rate of return over the life of a contract. For example, a five year fixed annuity with a 2% rate will earn interest at 2% per year for five years. After this, the rate will revert to an amount defined in the policy. At any time in the life of the contract, you can “annuitize” the contract and convert it into a guaranteed income stream. There are a number of factors that come into play in calculating the income level.

Pros of Fixed Annuities

  • Simple and easy to understand
  • Principle protection in a market downturn
  • Steady income stream when annuitized
  • Fixed, predictable rate of return

Cons of Fixed Annuities

  • May not keep up with inflation
  • No participation in market gains if stocks have a good year
  • Penalties for early withdrawal
  • Risk of issuer bankruptcy

Variable Annuities

If a fixed annuity is considered a risk-free product, the variable annuity is the free-wheeling cousin. Variable annuities are still insurance contracts like fixed annuities, however, your rate of return is tied to capital markets and is not fixed at a specific percentage. In good years, a variable annuity will greatly outpace a fixed one. In bad years, you could see your payments dwindle. 

Money placed into a variable annuity will be used in an investment portfolio, which can often be adjusted based on your risk tolerance. Variable annuities also have the option to add riders at additional costs that can offer lifetime income streams or enhanced death benefits. Variable annuities have lots of moving parts, and each contract has unique features and benefits.

Pros of Variable Annuities

  • Reap the rewards when markets produce outsized returns
  • Variety of investment strategies ranging from aggressive to conservative
  • More likely to keep up with inflation than a fixed annuity
  • Have the option to add additional benefits to provide income or death benefits

Cons of Variable Annuities

  • Full assumption of investment market risk
  • Potentially high cost
  • Negative impact of surplus withdrawals
  • Complex and sometimes difficult to understand

Fixed Indexed Annuities

To complicate matters further, let’s say that a fixed annuity and a variable annuity have a baby.  What do you get—fixed indexed annuities. Fixed index annuities combine some of the best parts of fixed and variable annuities into one product. As with a variable annuity, an indexed annuity has the potential for market appreciation with returns linked to a market index like the S&P 500. Additionally, similar to a fixed annuity, your principle is not subject to market risk. Fixed Index annuities allow you to gain exposure to market forces while taking market risk off the table.

Pros of Indexed Annuities

  • Principle protection with better rates than traditional risk-free products like CDs
  • Participation in market upside based on index chosen
  • Able to reallocate investments on contract anniversary
  • Typically, low/no direct cost to investors 

Cons of Indexed Annuities

  • Gains are capped—if the market does really well, you leave money on the table
  • Early withdrawals could lead to loss of principle
  • Crediting methodology may be confusing or based on a proprietary index and typically will not include dividends of index in return calculation
  • Cap rates can change every contract year

Immediate Annuities vs Deferred Annuities

Another important annuity distinction is immediate versus deferred annuities. An immediate annuity works just like it sounds—a lump sum payment is made upfront to the insurance company (no accumulation phase) and the payment stream begins right away. Immediate annuities can be fixed, variable, or indexed. Immediate annuities often have lower fees and commissions since a lump sum payment is made in advance, but you lose control (and access) over how those funds are dispersed once the contract is agreed upon. 

Deferred annuities can also be fixed, variable, or indexed. A deferred annuity can still be paid for with a lump sum upfront, but payouts are put off (deferred) until the agreed-upon payout phase begins. The accumulation phase can also be a steady stream of payments to the insurance provider. In the future, the insurance provider begins repaying the deferred annuity based on the fixed, variable, or indexed structure. This type of annuity can also be repaid in a single, lump-sum payment to the annuitant.

Choosing Annuities for Your Retirement Plan

Annuities break two of the cardinal rules of personal finance—they’re complex products and often have high fees attached. However, if you’ve maxed out your traditional retirement accounts and want another form of retirement protection, an annuity could make sense, especially if you’re concerned about market risk or outliving your money. As always, but especially with annuities, make sure they are only considered in the context of a comprehensive financial plan. Remember, commissions are high on annuities and insurance reps will be eager to sell them. Make sure you understand what problem you’re trying to solve or what you’re trying to achieve before purchasing an annuity

Josh Strange, CFP®

Work with an Independent Financial Advisor

We hope you understand the types of annuities and have a better idea of which may fit your needs. If you have any questions, an experienced, truly independent financial advisor from Good Life Financial Advisors of NOVA can assist you. Contact us today! 

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Disclosure

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. 

Fixed and variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value. 

Fixed Indexed Annuities (FIA) are not suitable for all investors. FIAs permit investors to participate in only a stated percentage of an increase in an index (participation rate) and may impose a maximum annual account value percentage increase. FIAs typically do not allow for participation in dividends accumulated on the securities represented by the index. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Withdrawals prior to 59 ½ may result in an IRS penalty, and surrender charges may apply. Guarantees are based on the claims-paying ability of the issuing insurance company.

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