Many consumers have shown increased interest in annuity products to provide lifetime, guaranteed income. In this two-part post I will discuss the six major types of annuities. The better you understand these products and how each works the more likely you are to find a solution that can meet your needs. There are six major types of annuities—fixed annuities, variable annuities, buffered or structured annuities, fixed indexed annuities, immediate income annuities, and deferred income annuities.
All product types, except for immediate income and deferred income annuities, can be purchased with either a single premium payment (e.g., $25,000) or by making a number of premium payments (e.g., $5,000 per year for 6 years or $1,000 per month). The latter is called a flexible payment schedule with the consumer making various payments in various amounts as they desire. Life insurers specify what minimum premiums are required for each product they sell. Both types of income annuities are usually purchased with a single premium payment.
There are a number of different product designs for each product type. The proper type of annuity contract and what is best for you depends on several variables, including your age, risk tolerance, need for access to cash in case of an emergency, fees you are willing to pay, income goals and when you want to begin receiving annuity income (e.g., now, at retirement, or at much older ages–say age 85).
Let’s look at the first three of the six major annuity product types.
Fixed Annuities
Fixed annuities earn a guaranteed rate of interest. All investments supporting this contract are managed by the issuing life insurance company which is financially responsible for all terms of the contract. Fixed annuity contracts earn interest at a rate that has historically been higher than bank products, such as certificates of deposit. With fixed annuity contracts you have the option to defer income or draw income immediately. These contracts are popular among retirees and pre-retirees who want a no-cost, principal protected and guaranteed fixed investment.
Multi-year guarantee fixed annuities or MYGAs is a term used to describe a fixed annuity that has an interest rate guarantee for the same period of time as its surrender period. For example, an annuity with a guaranteed interest rate of 3% per year for 5 years and surrender charges that last for 5 years, after which there are no surrender penalties, is a MYGA. Some MYGAs offer a higher or bonus interest rate the first year, and a lower, but guaranteed rate, for all subsequent years of the surrender period–e.g., 4.5% first year, with a guaranteed renewal at 3% for years 2-5. When considering these contracts, you need to calculate and understand what the contract’s return will be for the entire 5-year period.
Variable Annuities
Variable annuities are so named because their earnings and income payments fluctuate with the performance of specific investment funds that the contract owner designates for their premiums. All decisions about how the money in the variable annuity contract is invested are made by the contract owner from investment funds offered by the life insurer. These investments are made available to the contract owner by offering what are called subaccounts (equity, bond, and some fixed-return mutual funds).
The contract’s value is determined by the performance of the subaccounts. As this product offers investment subaccounts that are securities and could lose money, the financial professional selling you this product must have a securities license in addition to their license to sell annuity products.
Buffered or Structured Annuities
Introduced in 2010, buffered annuities (also referred to as variable indexed annuities, indexed linked variable annuities, structured annuities or registered index linked annuities) are a category of variable annuity products that is seeing significantly increasing sales according to the Secured Retirement Institute. I like the term buffered to describe them because this product buffers the loss the policyholder incurs if the investments underlying the annuity lose money.
In reality, these products have a mix of the characteristics of fixed indexed annuities and variable annuities. From a regulatory standpoint they are insurance products with an investment element and, as such, can only be sold by licensed insurance professionals who are also licensed to sell investment products. As you learn more about these products, you will see why. I highlight these products as a separate product type because of their increasing popularity and rapid sales growth.
Comparison to Other Annuities
How do buffered annuities compare to other annuities? First, they are similar to fixed indexed annuities as the products’ interest earned is tied to a particular index, such as the S&P 500 or the MSCI EAFE. Buffered annuities, however, allow the policyholder to capture much more of the upside of the index than a fixed indexed annuity but not all of the equity market increase like a variable annuity does. Unlike a fixed indexed annuity, a buffered annuity merely protects some of the downside and can cause a policyholder to lose money, similar to a variable annuity. The ability to lose money is why this product is considered an investment that requires a securities license to sell.
When you purchase a buffered annuity, you normally select the length of the index term you want (usually 1, 3, or 6 years), what index offered by the life insurer that you would like to participate in, how much protection from loss you desire, and the interest crediting method. These products offer a number of differing indices and crediting methods (e.g., caps/participation, spreads, and triggers).
The upside and downside limits of buffered annuities are connected. So, a higher level of protection from downside risk of loss means a lower cap on upside potential, and vice versa. When the underlying index performance is positive during a term, your annuity may earn interest credits limited by a cap or participation rate. Index declines can result in negative interest credits, mitigated by the level of protection you have chosen from any loss.
The Key Product Choice – How Much Downside Protection You Want
A "buffer" or a "floor" are two options that insurance carriers offer to limit exposure to market losses for these products. A buffer is the percentage of downside protection, typically 10, 20 or 30%. For example, if the index you have selected declines 15% and you choose a 10% buffer (loss to be absorbed by the insurance carrier), you would incur a loss of 5%. If you selected a 30% buffer, losses up to that amount are absorbed by the life insurance company. In exchange for higher buffer percentages, you get lower participation in the index you have selected.
A floor design is the opposite of the buffer option. In this case, you would be exposed to the percentage loss up to the floor amount, but you are protected against any loss after this percentage. For example, if you choose a product with a 10% “floor” and the market declines 15%, you will lose 10%, because the floor limits the downside.
Buffered annuities have the standard characteristics of all annuity products such as tax deferral, annuitization options, and death benefits equal to accumulated values but usually do not offer living benefits such as lifetime minimum withdrawals. Industry experts often say that this product category is for the variable annuity customer who wants to get protection from major potential losses.
Summary
There are six major types of annuities: fixed annuities, variable annuities, buffered or structured, fixed indexed annuities, immediate income annuities, and deferred income annuities. There are a number of different product designs for each product type. The proper type of annuity contract and what is best for you depends on several variables, including your age, risk tolerance, need for access to cash in case of an emergency, fees you are willing to pay, income goals, and when you want to begin receiving annuity income (e.g., now, at retirement, or much later in life, say after age 85). Annuities are a great tool to consider using in creating your retirement income plan.
Looking to learn more about the different types of annuities and get answers to your key questions? The FinancialVerse: Today’s Annuity Products - A Tool to Create Protected Lifetime Income explores the many benefits of annuities and how they can be a valuable addition to your financial plan.