Main Types of Annuities
What is an Annuity?
An annuity is a series of future payments made at set intervals. This stream of future payments is paid out to the annuity owner by an insurance company (typically). Most annuity owners have paid premiums to the insurance company and the money has grown in value. This is called the accumulation phase. The annuitization phase kicks in later, where the money is returned to the owner. These are commonly known as investment annuities. But pensions, lottery winnings and structured settlements are also types of annuities. In this this article we focus on investment annuities.
Most individuals are familiar with the mutual fund industry as the bedrock of defined contribution retirement plans. While the $220 billion annuity industry is a small part of the $24 trillion U.S. retirement market, it is fast-growing and with market volatility and strong demographics at its back, should remain a powerful retirement option.
Deferred-income annuities are relatively new, having only been around since 2011 when New York Life introduced the first deferred-income annuity contract. While the number of different investment annuities may seem overwhelming, they typically fall into these four main categories. Here are the most common types of annuities:
Immediate-Income annuities turn a lump sum payment into lifetime guaranteed income, beginning immediately.
How do Immediate Annuities Work
A person makes a lump sum payment to an insurance company and receives fixed payments (typically monthly) for a certain period of time. An immediate “life only” annuity pays the annuity owner monthly payments for life.
Here is a hypothetical example of an immediate “life only” annuity: A 60 year-old pays a $200,000 lump sum to an insurance company in exchange for immediate monthly payments of $1,001.65 which last for as long as the investor lives. This was an actual example from Barron’s 2014 ‘best annuities’ list and the insurance company in the example was American General (a.k.a. AIG). Which continue for the remainder of the investors life.
Immediate Annuity Pros and Cons
Immediate-income annuities shift the investment risk away from the individual investor and onto the insurance company.
If you own an immediate “life only” annuity and live a long time (perhaps to 100 years of age) the insurance company keeps paying you monthly checks. But…
In an immediate ‘life-only’ annuity, if the annuity owner dies before the principal is paid out, the insurance company keeps the remaining principal. This is a common criticism of these types of insurance policies-the earlier dying owners essentially fund the longer-living owners.
Insurance companies have actuaries that ensure the investor doesn’t have a leg up in the deal.
How Deferred Annuities Work
Deferred-Income Annuities take a lump sum and convert it into a future income stream for the annuity owner. Because of this structure, deferred annuity payments are sometimes referred to as a ‘Personal Pension’.
Here’s a hypothetical example of a deferred annuity. A 55 year-old puts in $200,000 lump sum with an insurance company. In turn, the insurance company agrees to begin paying him monthly payments of $1744.58 ($20,935 annually) beginning at age 65.
Deferred Annuity Pros and Cons
Provides an option for a ‘pension’ like product for the majority of working people that don’t have access to such defined benefit plans. Most pension beneficiaries are employed in the public sector, although there are some corporate pensions still in existence (though the number is dwindling).
Simplicity-You know exactly what you are going to get at a specific future date.
You don’t have to worry about making the right investment decisions (you shift the investment risk onto an insurance company).
Like the cons with most annuities, the fees are excessive. You may have been better off
You must consider the financial strength of the insurance company.
Fixed annuities are principal protected products and offer a guaranteed interest rate. But the values can also vary with financial markets, in the case of the fixed-index annuity. can be income annuities or accumulate assets like a bank CD. Fixed-index annuities are tied to some underlying index, often the Standard & Poor’s 500 stock index. The insurance company offers a floor on the return for investors through the use of derivatives.
How Fixed Annuities Work
As a hypothetical example, a 55 year-old pays a single-premium of $200,000 to an insurer and receives an income guarantee. At age 65, the annuitant receives $1,750 per month ($21,000 annually). By age 85, the total income paid would amount to $420,000 ($21,000 x 20 years= $420,000). This example was from an American General ‘Power Select Plus’ contract from 2014. New York Life annuities are also predominantly fixed in nature.
Fixed Income Annuity Pros and Cons
Certainty-Offer a guaranteed rate of return (principal protection).
Longevity risk shifts to the insurer from the annuity owner.
If you die before principal is returned, it stays with the insurance company.
The ‘income guarantee’ may require an additional rider, which adds to the expense.
Insurers often have the right to change the terms of the contract on an annual basis.
Fixed annuities may be subject to a Market Value Adjustment (MVA). This can be detrimental to the value of your fixed annuity in a rising interest rate environment.
How Variable Annuities Work
Variable annuities take the premium and invest them into sub-accounts containing mutual funds. As such, the value of the annuity can fluctuate extenseively. Still, variable annuities make up the lion’s share of the annuity industry presumably due to their tax-advantaged (tax-deferred) status and a long bull market in stocks. A variable annuity with guaranteed benefits was the highest selling annuity in the industry over the past decade, according to Barron’s.
Variable Annuity Pros and Cons
Investments grow tax-deferred.
May shelter money against a legal claim
High fees, at least 2% (including mortality and expenses) often totaling 3.5% or more annually, all in.
Long surrender periods associated with some variable annuities inherently make these products illiquid. For those in retirement, this runs contrary to generally accepted retirement advice.
Volatile- The value of variable annuities can fluctuate wildly, since the assets are invested in sub-accounts usually made up of mutual funds.
If held in certain retirement accounts, the tax benefit may be muted.
Annuities are not tax deductible since they are not qualified retirement products.
Poor legacy products-heirs receive no step up in cost-basis so they could incur a large tax bill.