Types of Annuities

As you plan for retirement, you might look at annuities as a way to help you build up your savings and provide lifetime income.

But there are a number of different types of annuities. What’s the difference, and why should you care? Each different type of annuity offers different benefits, but you generally have to give something up to enjoy those benefits.

To help make sense of things, let’s review your options along with a few highlights of each type.

All Annuities

First, it might be helpful to understand some features that are common with almost every type of annuity, and then we’ll see how they differ down below.

Insurance: annuities are insurance contracts issued by an insurance company. You might not care about that, but it’s important to realize that any money you put in an annuity (and any guarantee that’s part of an annuity contract) is at risk: if the insurance company goes out of business, you could lose money, or at least lose any benefits that were promised to you. Remember: you’re entrusting your life savings to a company, so it needs to be a strong one (most people say that 25-50% is about as much of your savings as you should put into annuities).

Tax deferral: annuities are tax deferred investments, meaning that you typically aren’t taxed on earnings within the account each year. Instead, you’ll pay those taxes when you take money out of the contract.

Surrender charges: when you put money in an annuity, the insurance company wants you to keep it there. If you pull your funds out “early,” you may have to pay surrender charges. Depending on the type of annuity you have (they’re generally lower with fixed annuities, and higher with equity indexed annuities) the charge might run from 5% to 20% or more of your withdrawal. You can often get a small portion (10%) of your account out without penalty each year, but it gets expensive after that.

Taking money out: with most annuities, there are two basic ways to get money out. First, you can often take your funds out in a lump sum (whether you’re going to transfer the annuity to a different account or you’re going to spend the money). However, there are some types of annuities that don’t allow lump sum withdrawals, so make sure you know what your options are before you buy. The second way to get money out is through an income stream: the insurance company can make payments to you for your entire lifetime, or for some set number of years.

Fixed Annuities

The appeal: fixed annuities are the most basic type of annuity: you put money in, the insurance company pays a little interest on your investment, and you can turn it into a lifetime income stream if you want (whether you do it right away, or someday down the road). You don’t have to choose investments or worry about market performance. Instead, the insurance company invests your money for you, and pays you a fixed interest rate.

Key risks: fixed annuities are low-risk investments for conservative investors. They might look and feel like souped-up certificates of deposit (CDs), but they are different – they’re not guaranteed by the government like your bank account is. Over long periods of time, you also run the risk of losing purchasing power due to inflation.

Variable Annuities

The appeal: variable annuities allow you to invest your money with the goal of earning more than you’ll earn from a fixed annuity. With this type of annuity, you select investment options (similar to mutual funds). Variable annuities might also include “living benefits” which are guarantees that the insurance company makes. For example, they might promise to pay out income for the rest of your life (while you keep the option to walk away with your money), or they might offer certain credits that you can use to take income later (but you generally can’t cash those credits out and walk away with a large lump-sum).

Key risks: variable annuities involve market risk. You have the potential to earn more than you get in a fixed annuity, but there’s also the potential that you’ll lose money in the markets. Variable annuities can also have longer surrender periods than fixed annuities, so it could be expensive to get your money if you need it. Guarantees with these types of annuities are also complicated, and they result in higher costs.

Equity Indexed Annuities

The appeal: equity-indexed annuities (EIAs) offer the potential for growth, but with less risk than you’d get with a variable annuity. These types of annuities are extremely complicated, so you really have to spend time researching them before you fall in love with their story, which is this: EIAs typically pay at least some small amount of interest, while giving you exposure to the stock market. If the market does well, your money grows more quickly (if not, you at least earn the interest).

Key risks: EIAs are hard to understand (and emotionally appealing), so it’s easy to believe you’re getting something that you can’t have. The benefits you get come at a cost. EIAs typically “cap” what you can earn from the market – if the market does extremely well, you probably won’t be on board for the entire ride (with a variable annuity, on the other hand, you participate in 100% of your portfolio’s gains – as well as 100% of the losses). These types of annuities also use strange calculations when measuring market performance, so your results might be disappointing. Finally, EIAs are notorious for long surrender periods and high surrender charges. Once you’re in, it’s not easy to get out.

Immediate and Deferred Annuities

The terms “immediate” and “deferred” refer to when you start taking payments from an annuity. With an immediate annuity, payments come out right away. With a deferred annuity, you wait indefinitely to take payments, or you might not ever take income from this type of annuity (instead, you might cash it out). After you’ve turned on an irrevocable income stream, it’s difficult to get money back in a lump sum unless you find a way to sell those payments.

More information: