What Type of Annuities Are There

Despite the security they have provided for millions of people for nearly a century, annuities were once thought to be stodgy and boring investments, nothing more than an interest bearing savings account with some guarantees and tax advantages. They’re issued by life insurance companies, and what can more boring than that? Well, for the last half of a century, life insurers have been cooking up smorgasbord of annuity products that has catapulted them to the height of popularity and controversy. Presently, with hundreds of products available, there’s likely to be one type of annuity for just about any long term investor. The number of choices can be overwhelming if not downright paralyzing. We break it down for you here so you can more quickly find the right annuity product for you.

Essentially, there are two primary types of annuities: immediate and deferred. Within these two broad categories you will find a number of variations which expands the number of different types of annuities. With each iteration and innovation of a new type of annuity, their complexity increases. For a better understanding of how even the most complex annuity product works, its best to start at the top of hierarchy with the most basic versions.

Immediate Annuities

Also referred to as life annuities, income annuities, single premium immediate annuities, these are based on the original concept of annuities introduced centuries ago. At their simplest, annuities were conceived as a straight exchange of capital for a stream of income. Citizens in the ancient world would hand over their life savings to the government in exchange for a guaranteed annual stipend. It was a way for governments to fund their armies and infrastructure projects.

Nowadays, immediate annuities are issued as contracts by life insurance companies who use your money to make investments from which they apply a portion of their return to your own annuity account. They then calculate how much income your principal deposit will generate over a specified period of time when it is paid out as a combination of a return of principal and interest. For people who seek a secure income they can’t outlive, the life insurer guarantees income payments for life, even if you live beyond your life expectancy. In essence, they underwrite your longevity risk.

Deferred Annuities

At one point, way back when, life insurers begin to recognize that most people didn’t have lump sums of capital to convert to income, so they added an accumulation component to their annuities. This enabled people to “defer” their income payments until such a time that they had accumulated sufficient capital. The accumulation component, or phase, of the annuity contract consists of an individual account to which the life insurer credits an annual interest payment. To discourage people from using their deferred annuity as liquid savings account, they instituted a surrender fee schedule which applies a charge to withdrawals that exceed 10% of the account’s value. The fees start out high (7 to 12 percent) and then decline by a percentage point each year until they vanish.

In the 1940’s, the U.S. government recognized the value of annuities as a retirement savings vehicle so it conferred upon them a favorable tax treatment, similar to qualified retirement plans, that allowed savers to defer taxes on earnings inside the contract. This made annuities a very popular choice for savers in the higher tax brackets, especially when the tax rates were as high as 70%. The earnings are eventually taxed upon withdrawal, plus, withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty.

At any point, a deferred annuity can be converted to an immediate annuity for guaranteed monthly payments. Once that is done, the principal balance is irrevocably turned over to the life insurer.

Have it Your Way

With the basic components of plain vanilla annuities well established – accumulation accounts, minimum rate guarantees, tax deferred earnings, guaranteed death benefit, guaranteed income – the life insurers began to add new flavors to attract investors of all stripes. It began with the introduction of variable annuities in the 1950’s and grew from there.

Variable Annuities

Essentially, variable annuities replaced the interest bearing accumulation account with separately managed investment accounts that enabled investors to allocate their funds among stocks, bonds and fixed vehicles. Unlike a fixed deferred annuity in which the account funds are invested in the insurer’s general account, these accounts are separate and the earnings are generated from the investments within them. Investors have the ability to transfer, free of taxes, between the accounts. Like mutual funds, variable annuities incur investment management expenses which are passed on to the investor.

Although they were an investor favorite during the roaring markets of the 1980s and 1990s, variable annuities came under criticism for their high expenses. They also became controversial when annuity salespeople began to target older people for whom these products with market risk, high expenses and high surrender fees may not be appropriate. More recently, insurers have been adding more guarantees, such as minimum withdrawals and minimum interest rates, which address the market risk concerns. While these guarantees increase the expenses, they make variable annuities much more palatable for risk adverse investors.

Indexed Annuities

With roaring markets comes volatility, and many investors, while they might like the upside potential, lose sleep with the wide fluctuations in the markets. So, insurers came up with a product that offers market-like returns in good markets while protecting the principal against downside movements. Indexed annuities are more like fixed annuities in that their yield is fixed for a year, however, the amount of the yield is based on the percentage gain in a stock index. When the stock index experiences a year-over-year gain, the insure credits a portion of that gain to the annuity account. In periods when the index declines, the insurer credits a minimum interest rate. It can be an ideal investment for people who want to earn more on their funds than a straight fixed yield, but can’t tolerate the up and down fluctuation of returns in the stock market.

Variable and Indexed Income Annuities

Both of these annuity variations also offer the opportunity to convert the accumulation accounts into income. The amount of the income payment is linked to the performance of the underlying investment accounts, or, in the case of an indexed annuity, a stock index. This can be ideal for people who want some portion of their income to have growth potential. And, with the added protections these annuities offer through guarantee options (at a cost), investors can achieve income growth with peace-of-mind.