An annuity is a type of tax-deferred investment that enables people to supplement their retirement income. The fundamental concept of an annuity is simple. However, there are several types of annuities, making the process of investing in them seem complex. The following explains how annuities are generally classified.
At a basic level, annuities are contracts between individual investors and insurance companies. The investor makes payments to an insurer, either as one lump sum or many payments over a period of time, and in return, the insurer gives them periodic income in the future.
People usually buy annuities to guarantee income during retirement. Annuity investors also enjoy the tax-deferred status of their investments, meaning they pay no income and capital gains taxes on the gains their investments make. They only pay income tax on the withdrawals they will make in the future.
The complexity of annuities arises from the various types that exist. There are different options depending on how an investor wants to purchase an annuity, how much they want to receive from it, and when they want to receive these payments.
Regarding how an investor wants to invest in annuities, there are single premium immediate annuities and flexible premium annuities. With the former, an investor makes a single lump sum payment to an insurer and starts receiving periodic disbursements in less than a year. About 10 percent of annuities sold are single premium immediate annuities. They are often preferred by people approaching retirement.
With flexible premium annuities, an investor opts to buy an annuity through multiple payments to an insurer. The payout, however, has to be deferred, meaning the investor will receive the benefits years later. Depending on the insurer, an investor can make payments on a fixed schedule (say every month) or flexibly.
Besides how an investor wants to pay, there are also annuity options based on how an investor wants their investments to grow. These are fixed, variable, and fixed-index annuities. Fixed annuities are low risk and highly predictable. Their investment returns are guaranteed through a fixed interest rate. Therefore, regardless of market fluctuations, investors with fixed annuities will receive their set monthly payment. State insurance commissions regulate these fixed annuities.
Variable annuities are higher risk but can offer higher returns. Here, the insurer allows an investor to direct their investments to different assets, usually mutual funds. Their payments vary, depending on the performance of these assets. In a strong market investors can earn high returns, but in a declining market these earnings shrink. The U.S. Securities and Exchange Commission regulates variable annuities.
Fixed-index annuities are a mixture of the above two. The investor receives a return that is tied to the performance of a market index like the S&P 500. They also have set minimum disbursements and protections against loss of principal.
Annuities are further differentiated based on when an investor wants to receive their payments. As mentioned, there are immediate annuities that start paying investors within a year of purchase and deferred annuities that start payments in the future. There are also different options based how long an investor wants to receive returns. Fixed-period annuities pay out over the course of a period, say 20 or 30 years, while lifetime annuities provide guaranteed life-time payments. Fixed-period annuities typically offer higher payments than lifetime annuities.
Over time, insurers have modified annuity structures further to cater to the unique needs of investors. For example, there are annuities that offer adjusted payments to protect investors from inflation. There are also joint and survivor annuities that provide death benefits to the beneficiaries of investors in case they die, and long-term care annuities that can provide payments for such care.
Individuals interested in buying an annuity should consult a financial professional to help them choose a suitable option based on their goals, risk tolerance, and preferences. The professional will also help them navigate unique annuity complexities such as fees and surrender charges.