Estimated reading time: 17 minutes

Imagine this scenario in your mind. You’ve heard about variable, fixed and indexed annuities, but you’re not too sure what they are or how they work, and you’re curious. You decide to ask someone you ‘think’ has their finger on the pulse of this annuity thing (they may even consider themselves an investor), and the preverbial flood gates open — only to leave you feeling more confused, and now overwhelmed. Sound about right?

Those who know you are ‘thinking’ about an annuity has likely (and openly) expressed their opinion. This entails everything they’ve heard (the good, the bad and the ugly), and everything they know (whether they really do, or not) and then suggest, “You should/shouldn’t [fill in the blank here]” And, I’m sure not too long-after all of those unsolicited opinions were received, you couldn’t help but notice just how widely that pendulum swung. Am I getting warmer?

Here’s the deal, if you’re planning for your retirement, you’ve likely heard that an annuity can be a way to create retirement income and defer year-end taxes. But what are annuities, and how can you tell if one is right for you?

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Comparing Annuities

There are many annuity products available, each with different features, associated costs and restrictions. With so many options, how can you determine which one is best suited to your retirement needs and objectives?  Let’s begin with their classifications. 

Classification of Annuities

This is where it can get a bit confusing as annuities typically are classified by several characteristics. The most common annuities are variable annuities, fixed annuities, and indexed annuities, and each one of these annuities are classified according to their underlying investments.

Variable Annuity

The funds in a variable annuity are invested in an investment portfolio, and the account value can fluctuate based on the portfolio’s performance.  In addition to receiving state oversight, variable annuities are regulated at the federal level by the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).

Fixed Annuity

A fixed annuity is invested in a fixed account, so the principal value will be guaranteed. In exchange for the guarantee, the rate of return is typically lower.  A fixed annuity also does not offer any inflation protection, which may be regarded as a disadvantage. 

Also, fixed annuities are regulated by state insurance commissioners.  That said, be sure to check with your state insurance commission about the risks and benefits of fixed annuities, and to confirm that your insurance broker is registered to sell insurance in your state.

Indexed Annuity

An Indexed Annuity (also known as “Equity-Indexed Annuities” or “Fixed-Indexed Annuities”) have characteristics of both fixed and variable annuities. Indexed annuities offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. Again, think of these as a hybrid of both fixed and variable annuities.

Many indexed annuities are based on broad, well-known indices like the S&P 500 Composite Stock Price Index. But some use other indexes, including those that represent other segments of the market. Even better, some indexed annuities allow investors to select one or more indexes.

Because of the guaranteed interest rate, indexed annuities give you more risk (but more potential return) than a fixed annuity, but less risk (and less potential return) than a variable annuity.  Also, an indexed annuity may or may not be a security; however, most indexed annuities are not registered with the SEC. Instead, indexed annuities are regulated by state insurance commissioners.

Variable Annuity Definition

So, what exactly is a variable annuity? A variable annuity is a long-term investment product offered by an insurance company that’s designed to help you save for retirement. You invest your money in professionally managed portfolios – similar to mutual funds.

Your money grows tax-deferred until you begin taking income at a later date. There is also often a standard death benefit that is included when you purchase your annuity, to help provide a legacy for your loved ones.

Investing + Insurance = 4 Advantages

This is where it gets interesting. When you combine investing and insurance into one product, it creates not only a unique product, but a powerhouse product that adds fuel to your retirement! Take a look at these four advantages:

  1. Choice and Flexibility
  2. Annuity Tax Benefits
  3. Opportunity for Guaranteed Lifetime Income
  4. Legacy Protection

Choice and Flexibility

One thing just about everyone can agree when it comes to investing, is the importance of diversification to help avoid the risk of losing money. Most variable annuities offer a range of investment options across a variety of asset classes, strategies, styles and sectors. Spreading your money among investments can help reduce your risk in down markets.

Variable annuities also allow you to transfer money among investment options within the contract without sales or withdrawal charges.

Tax Benefits

With a variable annuity, any growth in your account is tax-deferred, until you begin taking withdrawals at a later date (and when you may be in a lower tax bracket). What this means is that all the money that you would have been paid out annually in taxes , stays in the account, growing, until it is withdrawn.

Additional benefits include the added flexibility to rebalance, and strategically moving money within your investments, without incurring annual taxes.

It’s important to know that you can only take advantage of tax-deferral if you buy your annuity with money from outside of “qualified” retirement accounts, such as 401(k)s, 403(b)s and IRAs (because these are tax-deferred already). Many people choose to do so anyway, because they want to take advantage of the annuity’s other features and benefits, including death benefit options, range of investments and guaranteed income payout options.

Income Guarantees

Annuities provide two ways to guarantee your retirement income; so it’s time to make it rain.

Annuitization:

When you’re ready to start taking income, you can annuitize. This means you would turn over control of the money in your account to the insurance company, in return for a regular stream of income payments in retirement.

Those payments would continue either for life, for a specified period of time (often 10, 20 or 30 years), or for a combination of the two (eg. life with 10 years). When you pass away, the insurance company would fulfill any remaining payment obligations, to your beneficiaries, for the elected time period, and keep any remaining money.

Optional Lifetime Income Guarantees:

In addition to annuitization, today’s annuities offer living benefits, for an additional fee, that function in a similar way to annuitization, but with more flexibility. These benefits provide income guarantees – including lifetime income – that essentially ensure your future income, without giving up total control of your money.

When you purchase a variable annuity with an ‘income guarantee’, your future income level can be protected, even if your account’s investments perform poorly. In addition, some living benefits offer guaranteed income growth as well as the opportunity to capture gains when the market goes up. Once you begin taking income, you can withdraw up to a specific amount each year as a guaranteed income stream for life, subject to the limitations outlined in your contract.

Typically, these optional lifetime income benefits are available for an additional fee, but also can be built into the annuity.

Legacy Protection

Fortunately, most annuities today offer a standard death benefit to help provide a legacy for your loved ones. It typically works like this: After the owner dies, the beneficiaries will receive at least what the owner has paid into the annuity, minus any withdrawals, OR the current account value of the annuity, whichever is greater.

This death benefit is usually built into the variable annuity at no extra cost. Some annuities do offer enhanced death benefits for an additional fee, so again, read your contract.

Things to Consider When Purchasing a Variable Annuity

  • Will you use the variable annuity primarily to save for retirement, or a similar long-term goal?
  • Are you willing to take the risk that your account value may decrease, if the underlying mutual fund investment options perform badly?
  • Do you understand all of the fees and expenses that the variable annuity charges?
  • Do you intend to remain in the variable annuity long enough to avoid paying any surrender charges, if you have to withdraw money?
  • Are there features of the variable annuity, such as long-term care insurance, that you could purchase more cheaply, if purchased separately?
  • Have you consulted with a tax adviser and considered all the tax consequences of purchasing an annuity, including the effect of annuity payments on your tax status in retirement?
  • If you are exchanging one annuity for another one, do the benefits of the exchange outweigh the costs? Such as any surrender charges you will have to pay, if you withdraw your money before the end of the surrender charge period for the new annuity?

If you’d like to dive deeper into the variable annuity pool, be sure to check out the SEC Guide to Variable Annuities.

Fixed Annuity Definition

A fixed annuity is a financial tool that promises a guaranteed minimum rate of interest on the principal amount while your account is growing. The insurance company also guarantees that the periodic payment will be for a set amount for a fixed period, such as 20 years, or an indefinite period, such as your lifetime.  

Although the word “fixed” might suggest otherwise, the interest rate on a fixed annuity can  change over time. The contract will explain whether, how and when this can happen. Often the interest rate is fixed for a number of years and then changes periodically based on current rates.

Things to Consider When Purchasing a Fixed Annuity

While a fixed annuity can remove market risk from your returns, there are other risks to consider when deciding if a fixed annuity is for you.

  • An annuity’s “guarantee” is only as strong as the insurance company that issues the annuity. There may be state guarantees in the event of an insurance company’s failure, but annuities are not guaranteed by the FDIC, SIPC or any other federal agency if the insurance company that issues the contract fails.
  • Payments in a fixed annuity typically do not have cost-of-living adjustments to keep pace with inflation, so the value of the money you receive in your payments may decline over time. Annuities with inflation protection can be purchased but the cost, in general, is significantly higher.
  • It may be difficult to get your money back once you pay the premium to the insurance company. Even if you only receive a few payments under a fixed annuity contract, the insurance company may not be obligated to continue payments to your spouse or refund your premiums to your estate.
  • If there are changes to your fixed annuity and you want to withdraw your money early, you could incur surrender charges that cut into your returns.

Fixed Indexed Annuity Definition

A fixed indexed annuity (FIA) is a tax-deferred financial tool designed for the long-term that is offered by insurance companies. Your account value is protected against market loss, but has the opportunity to grow based on the performance of an index, or combination of indices that you choose.

With an FIA, your money is not actually invested in any index, but may earn interest based on the index’s performance. To help balance the value of the downside protection, the insurance company typically imposes an upper limit, known as a “cap” on the amount of potential interest credited (in a given period), as well as a “floor” that offers downside protection.

Again, it is important to remember you cannot lose money based on market decline, and it’s that peace of mind that makes fixed indexed annuities so attractive.

Also, you can allocate some or all of your money to a fixed rate strategy that earns a guaranteed interest rate. When you feel the time is right to start receiving income payments, you can annuitize your contract for a specific period of time, or for the duration of your life.

How a Fixed Indexed Annuity Works

Fixed indexed annuities typically offer you a choice of strategies for potentially growing your money: a fixed interest rate option, and index-based options that credit your interest based on a cap rate or participation rate strategy.

The fixed interest rate strategy earns a guaranteed interest rate for a period of one year. The interest rate is declared at the time you purchase your contract, and renews annually on your contract anniversary date — at the new current rate.

With index-based strategies, your money has the potential to grow based on the performance of one (or more) market indices, such as the S&P 500®. The interest rate you can earn is usually calculated over a predetermined time period, and can vary based on the features of the annuity, including the option to allocate your money into a strategy based on a cap rate or participation rate.

A cap rate is the upper limit of interest that can be credited during the term. A participation rate is also an upper limit, on what can be credited, but is based on a specified percentage of the index’s performance. Cap rates and participation rates are set at the time of your initial contract purchase, and reset after each term.

Your principal and earnings are protected by the safety of a floor. The floor prevents your annuity from losing value even if the index declines during your term. Your principal and any interest credited are protected. You cannot lose money based on market performance.

Opportunities for Growth

Annuities with ‘optional benefits’ typically provide two opportunities for growth of your retirement income: the roll-up rate, and the opportunity to lock in account highs.

When you purchase optional benefits, the roll-up rate is the guaranteed growth rate of the annuity. It is set at the time your application is signed and does not change for the life of your benefit.

Also, some optional benefits have lock-ins, which help you capture market gains for your annuity account at a specific point of time. Typically, annuities offer the ability to lock in account highs annually, quarterly, or monthly. Some even offer daily lock-in opportunities, so no matter how the market performs your retirement income can continue to grow each day.

Annuity Accumulation Phase

There are two phases to a deferred annuity:

  1. The Accumulation Phase
  2. The Payout (Annuitization) Phase

During the accumulation phase, you are making payments and your annuity is accumulating interest on a tax-deferred basis. How this accumulation occurs varies depending on the annuity type you have.

Accumulation Phase Based on Type of Annuity

  • If you have a variable annuity, your issuing company will invest your premium in stocks, bonds and other short-term money market products, known as “subaccounts,” that mirror mutual funds. Your rate of return will depend on the performance of these subaccounts.
  • If you have a fixed annuity, your investment will accrue interest at a fixed rate that will not drop below a minimum guarantee.
  • If you have an indexed annuity, your investment is tied to the performance of stock-market measurements.  This includes the S&P 500. Your contract guarantees a minimum interest rate — even if the performance of the stock market index declines.

Annuity Payout (Annuitization) Phase

Fixed and variable annuities traditionally offer either deferred income or immediate income. Deferred income begins at a future date, which allows the account value to grow tax deferred. Immediate income payments start right away or within a year of your purchase.

You can opt to receive payments for the rest of your life, or for a set number of years. How much you receive depends on a payout stream determined by the performance of your annuity’s underlying investments (variable annuity), or whether you opt for a guaranteed payout (fixed annuity).

Systematic Withdrawals

When funds are dispersed via systematic withdrawal, the annuity can be withdrawn or disbursed through periodic taxable payments. Any remaining money continues to earn interest until the account has been depleted.

Under the annuitization distribution plan, the conversion of the accumulated value of the annuity contract becomes a stream of monthly, quarterly, or semiannual payments for as long as the annuitant is living, or for a specific number of years. This is where you choose how you want your eventual payouts to be calculated. Here are a few examples:

Income for Guaranteed Period (also called Period Certain Annuity)

You are guaranteed a specific payment amount for a set period of time (five years or 30 years). If you die before the end of the period, your beneficiary will receive the remainder of the payments for the guaranteed period.

Lifetime Payments

A guaranteed income payout during your lifetime only; there is no survivor benefit. The payouts can be fixed or variable. The amount of the payout is determined by how much you invest, and your life expectancy. At the time of your death, all payments stop – meaning, your heirs receive nothing.

Income for Life with a Guaranteed Period Certain benefit (also called Life with Period Certain)

A combination of a life annuity and a period certain annuity. You receive a guaranteed payout for life that includes a period certain phase. If you die during the period certain phase of the account, your beneficiary will continue to receive the payment for the remainder of the period. For example, life with a 10-year period certain is a common arrangement. If you die five years after you begin collecting, the payments continue to your survivor for five more years.

Joint and Survivor Annuity

Your beneficiary will continue to receive payouts for the rest of his or her life after you die. This is a popular option for married couples.

It’s worth noting that when comparing the ‘Joint and Survivor’ option to the ‘Lifetime’ option, the Joint and Survivor payout would be less, but a payout would continue on after one spouse passes away. With regard to the Lifetime option, when one spouse passes away, the surviving spouse would receive nothing.

Lump-Sum Distribution

In a lump-sum disbursement, an annuity is distributed as a one-time, taxable single payment.

What Annuities Can Do for You

Annuities can be an important part of your financial planning, and one might be a fit for you depending on your retirement needs and long-term goals.

  • A variable annuity can provide guaranteed income and investment flexibility
  • A fixed annuity with a guaranteed lifetime withdrawal benefit can provide guaranteed income for the rest of your life, starting on a date you select when you’re ready to start receiving income.
  • An indexed variable annuity can be customized based on your unique needs and circumstances
  • A fixed indexed annuity can offer protection from market loss and opportunities for growth
  • Create lifetime income and guaranteed growth without exposure to market risks and principal protection
  • Offer flexible, tax-efficient investing
  • Provide a standard death benefit to help provide a legacy for your loved ones

There you go — now you are familiar with all the information surrounding variable, fixed & indexed annnuities. Hopefully, you will feel more confident when you select an annuity. There are many options out there to help you find the type you need in almost any situation!

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