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Updated on Wednesday, August 11, 2021
Understanding how annuities work is an important first step in determining whether they fit into your retirement plans. Annuities can be customized in many ways, although they fall into three broad categories: fixed, indexed and variable.
An annuity is a contract between you and an insurance company. In exchange for giving the company money today, you receive a lump-sum payment or series of payouts in the future. For example, you could purchase an annuity with a single payment when you retire and then receive monthly payouts for the rest of your life.
Annuities offer long-term, tax-deferred savings, making them a potentially helpful tool for retirement. But because there’s such a wide-range customization available, it can be confusing to understand all your options. Our guide covers the basics on the different types of annuities: fixed, indexed and variable.
What is a fixed annuity?
A fixed annuity is one of the simplest types of annuities — it’s somewhat similar to a certificate of deposit (CD) account. You fund a fixed annuity with a single payment or a series of payments. The insurance company guarantees this principal amount, a minimum interest rate and a number of payments in the future.
The interest rate applies to your principal balance, and your account grows tax-deferred during the accumulation phase. At the end of the accumulation phase, your payout period begins. You’ll then receive a single lump-sum payout or periodic payouts, such as monthly or annually.
“When you first buy a contract for a fixed annuity, the payout amount will be specified,” according to Ken Tumin, founder of LendingTree-owed company DepositAccounts.com, so you’ll know how much income to expect later. Also, depending on your contract, the periodic payouts could be guaranteed for a certain number of years, until you die or until you and a beneficiary (such as a spouse) die.
Fixed annuity pros and cons
Fixed annuity pros
- This type of annuity is relatively easy to understand.
- You’ll receive a guaranteed interest rate and payouts.
- You’ll know the payout amount and payout period when you first buy the contract.
- There’s little risk of losing your savings.
Fixed annuity cons
- The interest rate may be lower than what you could receive from other savings or investment products.
- The interest rate could be lower than inflation in the future.
- Fees may eat into your savings and decreases your payout amount.
- You might not be able to take money out of the annuity without paying additional taxes and fees.
Who should invest in fixed annuities?
A fixed annuity may be the most attractive type of annuity if you’re looking for stability and guarantees. However, think carefully about when and why you’re buying the contract, as the interest rate you lock-in during the purchase will influence your payouts.
“If the interest rates start to bottom, it might not be the best time to get a fixed annuity,” said Tumin. “If you think rates are going up, wait for a few years until there’s a better interest rate environment.”
What is a variable annuity?
A variable annuity may feel more like a 401(k) or individual retirement account (IRA) than a certificate of deposit. However, a 401(k) and an annuity have key differences. When you buy a variable annuity, you can choose to invest your money in different financial products, such as mutual funds.
Your earnings during the accumulation phase depend on how well your investments do, which will impact your future payouts. The insurance company may offer optional riders that limit how low your account’s value can drop and guarantee you a minimum payout.
You may also be able to choose to receive the payout as a lump sum, over a fixed number of payouts or until you die. If you choose periodic payouts, the payout amount could either be pre-set or it may vary with your investment returns.
Variable annuity pros and cons
Variable annuity pros
- You could earn higher returns and have larger payouts than you would with a fixed annuity.
- Earnings are tax-deferred.
- The SEC generally regulates variable annuities.
Variable annuity cons
- You may have to pay higher fees than you would with other tax-deferred accounts.
- Your payouts count as ordinary income rather than capital gains and may be taxed at a higher rate.
- You could lose the money you put into the annuity.
Who should invest in variable annuities?
A variable annuity can offer tax-deferred investment growth and an additional source of income during retirement. “But a lot of the best variable annuities are basically a wrapper around investment options like mutual funds,” says Tumin. The wrapper analogy can apply to other tax-deferred accounts, such as 401(k)s and IRAs, although those may offer more investment options and fewer fees.
“For those who’ve maxed out their 401(k)s and IRAs, a variable annuity can be a reasonable option,” says Tumin. Until that point, you may want to focus on investing in other, lower-cost accounts instead.
What is an indexed annuity?
Indexed annuities often offer a minimum interest rate on your money, but are also tied to an investment index, such as the S&P 500. Depending on how the index performs, you may receive more interest earnings than the minimum rate. However, there are also often caps on how much you earn.
For example, if the S&P increases by 8%, you might only receive 3% of the gains — your cap — and the insurance company keeps the remainder. On the other hand, if the S&P decreases in value in a year, you might still receive a minimum interest rate gain rather than losing money.
The specifics of your annuity can also impact your earnings because the contract will dictate the cap, how much of the index’s gains your receive, the fees you’ll pay and how often the insurer reviews the index to calculate gains.
Indexed annuity pros and cons
Indexed annuity pros
- Offers a mix of guaranteed and investment-based tax-deferred earnings.
- Limits the potential for losses compared to variable annuities and other investments.
Indexed annuity cons
- Although your money gets invested, the SEC and FINRA might not regulate indexed annuities.
- Your gains are limited by the insurance company’s fees and caps.
- Can be particularly hard to understand and compare to other savings and investment options.
- Although there could be minimums, you might lose money on your investment.
Who should invest in indexed annuities?
Index annuities can seem like the best of both worlds — protection against investment losses with the potential to earn more than you would with a fixed annuity. But it’s not all good news, as the fees and caps can eat into your potential investment returns, particularly during high-growth periods.
“For those that are very conservative, the indexed annuity could give you a better return than a fixed annuity,” says Tumin. However, as with variable annuities, he suggested looking into other tax-deferred investment accounts, such as 401(ks) and IRAs, before an indexed annuity.
Deferred annuity vs. immediate annuity: What’s the difference?
You can purchase these three types of annuities as either deferred or immediate annuities.
With a deferred annuity, your contract begins with an accumulation phase. During this phase, the interest or investment earnings get added to your account balance, and you may be able to make additional contributions to increase your account’s value. At the end of the accumulation phase, you’ll start to receive payouts (either in a lump sum or periodically) based on the account balance and the terms of your contract.
Immediate annuities start to pay immediately based on your payment schedule. So, if you receive payments monthly, your first payment will start a month later. But if you receive annual payments, you’ll wait a year for your first payment.
Deferred annuities can be a better option if you’re planning ahead for retirement, or are in retirement but have other sources of income. An immediate annuity may be a better option if you’re in retirement and want to lock-in an income stream.
There are different types of annuities, payout structures and a wide range of riders that can make comparison shopping extremely difficult. Add on the fees, brokers’ commission-based sales arrangement and the possibility of losing your “guaranteed” income stream if the insurance company goes under and annuities look much less appealing.
Still, that’s not to say annuities are all bad. An annuity can offer a steady income stream during retirement, with an option to continue the income stream as long as you’re alive (or even beyond).
However, if you’re considering purchasing one, continue doing your due diligence and learning about the differences between annuity providers and contracts.