The Basic Types of Annuities and How They Work

My Comments: Like so many financial products, annuities come in a variety of forms that have surfaced over the years in attempts to both solve peoples financial problems and to make money for the companies offering them.

As you can imagine, the spectrum along which any one of them can be judged is wide, with useless on one end and fantastic on the other. Where any given annuity falls depends on which end you reside. Does it make a lot of money for you the company or does it make financial sense for you the consumer.

But you have to start with a basic understanding of the types of contracts that exist out there and what you read here is not definitive. I have my preferences based on my experience, and on my commitment to making sure whatever I recommend fits within the strategic goals of any specific client.

That being said, the industry is continuing to evolve. Contracts I thought were state of the art for consumers 8 years ago have been eclipsed by new iterations that while still making money for the company, provide far more upside potential for the buyer than could be found 8 years ago. Complicating all this is that in two or three years, new ones will probably surface that are even better for the consumer.

by Scott Krase \ October 16, 2018

Deciding if you should invest in an annuity is a decision that should only be made once you have thoroughly researched and have a full understanding of exactly what an annuity is.

An annuity is a contract in which an insurance company makes a series of income 
payments at regular intervals in return for a premium or premiums you have paid. 
Annuities are most often bought for an immediate or future retirement income. These would be called immediate annuities or deferred annuities. 
Annuities are designed to give investors long-term income as a retirement planning vehicle.

People typically buy annuities for safety of principle and guaranteed lifetime income. 
However, when you work with a commission-based broker, advisor or bank representative, they typically want to sell you an annuity for the commissions they’ll receive.

There are generally three types of annuities: variable, fixed and indexed. Understanding the three main types of annuities will help you determine which one, if any, are beneficial for you and your financial goals. It will also give you a better understanding of the potential risks and benefits these products provide.

Fixed Annuities

The insurance company agrees to pay you no less than a specified rate of interest during the time that your account is growing. The insurance company also agrees that the periodic payments will be a specified amount per dollar in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.

In other words, you are guaranteed a minimum rate of return over a specified period of time and generally don’t suffer losses because of these guarantees, but that return guarantee can be too low for your financial goals.

Variable Annuities

In a variable annuity, you can choose to invest your purchase payments from among a range of different investment options, typically mutual funds. The rate of return on your purchase payments, and the amount of the periodic payments you eventually receive will vary depending on the performance of the investment options you have selected.

Indexed Annuities

The insurance company credits you with a return that is based on changes in an index, such as the S&P 500 Composite Stock Price Index. Indexed annuity contracts also provide that the contract value will be no less than a specified minimum, regardless of index performance. Be aware the benchmarks for this annuity do not pay dividends.

Regulation of Annuities

Variable annuities are securities regulated by the Securities and Exchange Commission (SEC). An indexed annuity may or may not be a security. However, most indexed annuities are not registered with the SEC. Fixed annuities are not securities and are not regulated by the SEC.

Other Types of Annuities

There are a number of other annuities, so here is a more detailed list:

Not All Annuities are Bad

Not everyone needs an annuity, but hating all annuities is like hating all mutual funds. Some are good, some are below average, but not all are bad.

Annuities are contracts that help transfer risk. There are four primary areas of risk that annuities are used for.

  • Lifetime income
  • Principal protection
  • Wealth transfer
  • Long-term care

If you do not need any protection with one or more of these risks, then you probably don’t need an annuity.

You should review your current financial situation and see if an annuity might be a good fit for you before having a knee-jerk reaction to them. They have helped many people plan for retirement when used appropriately.

There are many strategies on how annuities can help investors plan for retirement, but it’s helpful to have an honest conversation with an advisor who has your best interests in mind, who puts their clients first, and who will help you achieve your retirement goals versus one looking for a commission sale.