Lorand Fabian - BFF Enterprises
Annuity Specialist
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The 3 Main Types Of Annuities
Which Annuity Type Is Best For Your Retirement?
What Are The 3 Main Types Of Annuities?
The 3 primary types of Annuities are Fixed Annuities, Variable Annuities, and Indexed Annuities.
Each have their own advantages and disadvantages depending on your current financial situation, risk tolerance, and retirement goals.
In this article, we're going to break down each type of Annuity in detail and give the advantages and disadvantages of each so you have the knowledge you need to determine which type of Annuity is best for your retirement.
Annuity Type #1: Fixed Annuities
Fixed annuities are the simplest and most straightforward type of annuities. They also provide the most predictable and reliable income stream, usually with the lowest fees.
A fixed annuity can be immediate or deferred. Meaning, depending on your contract, you may start receiving annuity payments within a year of purchasing your fixed annuity or you may have the payments start at a later time. Deferred annuities typically start payments when you actually retire.
To break it down further, a fixed annuity is a contract between you and an insurance provider. It provides a way to save money over the long run, allowing interest to accumulate tax-deferred.
You're essentially paying for a steady stream of income. The insurance company guarantees your principal, as well as a minimum interest rate that will be earned.
It's also important to note that unlike variable annuities and indexed annuities, fixed annuities are not linked to the performance of a portfolio or other investment, which is why they usually have less fees.
These are the main Pros and Cons of Fixed Annuities:
Pros
- Guaranteed minimum interest rate: A fixed annuity will never earn less than the guaranteed interest rate, regardless of the how the insurance company's investments perform.
- Principal protection: You cannot lose your initial investment (the amount of premium you put into the annuity) with a fixed annuity.
- Income for life: When you purchase a life annuity contract, you are guaranteed by the contract to never outlive your income payments.
- Simple: Unlike variable and indexed annuities, fixed annuities have no complicated formulas for determining the amount of money you will receive in income payments.
- Lowest risk: Interest credited is not dependent on the performance of investments, stocks, or stock indexes. This is particularly important for retirees who can’t afford to lose the money they need to pay living expenses.
Cons
- Low growth potential: The main disadvantage is fixed annuities don't have the potential for growth that riskier annuities have of yielding greater interest rates if an investment portfolio or stock index does well.
- No capital gains tax rates: Money withdrawn from annuities is taxed as ordinary income. It does not get the benefit of lower capital gains tax rates.
- Penalties for early withdrawals: Because annuities are designed to help people save for retirement, if you withdraw money from any annuity prior to age 59½, you will be subject to hefty fees and penalties.
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Annuity Type #2: Variable Annuities
A variable annuity is a type of annuity whose value is tied to the performance of an investment portfolio.
Payments from variable annuities can increase if the portfolio performs well and decrease if it loses money.
Although variable annuities carry the potential of higher returns than fixed annuities, they don’t offer a guaranteed payout.
A variable annuity is a contract between you and an annuity provider — usually an insurance company — in which you purchase the ability to receive a stream of income for your life or a set period of time.
The money you pay is allocated to an investment portfolio, of which you may have the option of selecting a predetermined portfolio that aligns with your risk tolerance and investment goals.
Usually, the annuity company guarantees return of premium (ROP), which means that you won’t lose your initial investment. But if your portfolio doesn’t perform well, you may not earn any growth. On the other hand, if your portfolio performs well, you have the potential for greater gains. Here are some pros and cons of variable annuities:
Pros
- Possible hedge against inflation: If your investment portfolio performs well, you have the potential to see an increase in your payments, enabling you to better keep up with inflation.
- Tax-deferred growth: You don’t pay taxes on earnings until you retire and start taking payments from the annuity.
- Initial investment protection: Many annuity companies will guarantee that you will not lose your initial principal amount invested, even if you make no interest due to poor portfolio performance.
- Death benefit: In addition to receiving income for life, if you die before you start receiving payments, your beneficiary will receive a payout from the annuity company.
Cons
- No guaranteed return: Unlike fixed and indexed annuities, there is no guarantee that you will earn interest on your investment.
- Taxed as regular income: When start taking payments from your annuity, the earnings are taxed as income, not at the capital-gains tax rate.
- Complexity: Because variable annuities involve an investment into stocks, indexes, etc., they can get quite complicated and can lead to confusion about what to expect from the annuity.
- Administrative Fees: Administrative, as well as a variety of other "fund" fees are often quite higher for variable annuities
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Annuity Type #3: Indexed Annuities
Indexed annuities feature a guaranteed return plus a market-based interest credit method.
The result is a greater potential upside than a traditional fixed contract, with less risk than a variable annuity because your principal is not actually invested in the stock market.
It's only "linked" to a stock market index (like the S&P 500) as a method of crediting your account with interest based on the performance of that index.
They offer protection against stock market losses, as well as the potential to profit from the market’s gains, although these gains are usually capped at a certain percentage.
For example, let's say the S&P 500 goes up 15% but your cap rate on your Indexed Annuity is only 6%, your annuity contract would only receive 6% of that overall move up.
However, if the S&P 500 went down 15%, your principal would be safe (unlike a 401k for example) and you would even receive the minimum guaranteed interest rate based on your specific contract.
These are the main Pros and Cons of Indexed Annuities:
Pros
- Growth without risk: You have the potential for stock market growth without actually risking your money in the stock market.
- Principal protection: If the stock market loses value, you don’t lose money like you would in a traditional investment account.
- Index gains are locked in: If the stock market goes up and your account is credited those gains for the year, they are locked in, even if the stock market goes down the next year.
- Lifetime income: In addition to the potential for growth, you also create guaranteed income for life because it's still an annuity contract.
Cons
- Limited market growth: The gains of your contract will be capped and won’t reflect the entire increase in the value of the stock market index your annuity is linked to.
- Fees and expenses: Some indexed annuities can be quite expensive. Make sure that ALL of the fees associated with your contract are fully disclosed and understood.
- Lower cap changes: Your cap or participation rate could change in the future. For example, your contract may have a 6% cap rate right now, but may fall to 4% or 5% later depending on the markets.
Conclusion
As we usually say when it comes to annuities, one individual type of annuity is not necessarily better than another. They all have their pros and cons.
It always comes down to your specific retirement goals that determines what type of annuity is best for you.
That's why we always recommend working with an Annuity Specialist that has access to a large variety of different annuities and providers to help you choose the best one for you. So click the button below to request your own Custom Annuity Retirement Plan.
