This article was updated on June 8th, 2016.
Annuities draw a lot of controversy in the financial world for such a simple financial instrument.
An annuity is a contractual arrangement with an insurer to exchange an upfront premium for future (usually retirement) payments. Retirees then have a guaranteed income that isn’t subject to stock market swings. There are four main types of annuities:
- Immediate annuities
- Deferred income annuities
- Fixed annuities
- Variable annuities
I’ll get to those in more detail below. But first, a few general thoughts: While some see annuities as a perfect solution to many different financial issues, others focus on some of their weaknesses, which can include high costs and complicated features that can be difficult for typical investors to understand. In reality, various types of annuities have pros and cons that can be much different from one to another, and making sure you choose the right type of annuity for your situation is a key factor in figuring out whether any annuity is right for you.
1. Immediate annuities
An immediate annuity is the easiest type of annuity for most people to understand, because in its most common form, it has very basic provisions. A typical fixed immediate annuity involves your making a lump-sum payment to an insurance company upfront, in exchange for the right to receive payments from the insurer on a regular basis beginning immediately. You can structure an immediate annuity to pay for the rest of your life, for a fixed period of time, or for as long as you and another person you choose as a beneficiary are still living.
Payouts on most immediate annuities are interest rate sensitive, and so when rates are low, the amount of future income you'll get from an immediate annuity can be relatively small. In addition, if you choose an immediate annuity based solely on your life and you die shortly after buying the annuity, the money spent on the annuity premium can be lost if you don't choose a specific insurance rider for your contract. Still, as a way to guarantee a stream of income for as long as you live, an immediate annuity can be extremely useful.
2. Deferred income annuities
Unlike immediate annuities, deferred income annuities don't start making payments right away. In most other respects, though, they closely resemble immediate annuities. With a deferred income annuity, you pay a certain upfront amount, and in exchange, the insurance company promises to pay you a certain amount once you reach the age specified in the annuity contract.
Many people use deferred income annuities to protect against longevity risk, with payouts kicking in at age 80 or 85 that can provide supplemental income when you most need it. These annuities are also somewhat sensitive to interest rates, but the payouts can be much higher than with immediate annuities because of the wait to receive payments and the chance that you'll pass away without reaching the specified age. The trade-off is that it's more common for people to end up getting nothing from a deferred income annuity, because many won't reach the future age at which benefits kick in.
3. Fixed annuities
A fixed annuity is an annuity whose value increases based on stated returns within the annuity contract. Typically, fixed annuities don't have payments begin right away and are therefore deferred annuities, but unlike a deferred income annuity, you retain the flexibility to choose if and when to start receiving payments from the insurance company under the contract.
Interest rates can be higher on fixed annuities than on bank CDs and other popular income investments, and they're also tax-deferred. Yet you have to be careful about whether you can get access to your money when you need it, along with any penalties and tax consequences that might follow. With surrender charges that can make it costly to tap into an annuity within the first several years, you need to look at the specific provisions of a fixed annuity to make sure you can access it.
4. Variable annuities
Unlike a fixed annuity, a variable annuity's returns are tied to a certain market. Whether it's the stock market, the bond market, a combination of the two, or a more specific investment niche, variable annuities can give you exposure to a broad set of investments along with the protections that annuities provide. Specifically, variable annuities often come with guarantees of minimum amounts of income, withdrawable cash, or death benefits that can give them an advantage over ordinary stocks and bonds.
Like fixed annuities, variable annuities are tax-deferred, but the advantage of having a broader range of available investments appeals to many, as do the guarantees. Fees can be expensive, with both surrender charges limiting cashing out and ongoing annual fees for guarantees and mortality expenses eating into your total return. It's smartest to shop for the cheapest expenses available as long as the insurance company's rating is secure.
Keep in mind that there are other types of annuities beyond these four, and many insurance companies use names that are slightly different than these. Nevertheless, if you understand what these four types of annuities are, it should help you deal with whatever products your insurance agent presents to you and assess whether they're a smart move for your financial portfolio.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.