In this post, I will discuss the next three of the six major types of annuities that you can select from to help meet your financial challenges. 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).
Here's a discussion of the next three product types.
Fixed Indexed Annuities
A fixed indexed annuity (also known as an equity indexed annuity) is a type of fixed annuity that grows at the greater of a) an annual, guaranteed minimum rate of return; or b) the return from a specified stock market index (such as the S&P 500), reduced by certain expenses and carrier mandated limitations. This type of annuity has grown in popularity in the past decade. The guaranteed minimum return differentiates the fixed indexed annuity contract from a variable annuity which does not have such a minimum and where, in fact, you can lose money.
Fixed index annuities offer the ability to participate in some of the gains associated with a raising equity market while at the same time having strong contractual minimums. These contracts do not produce equity market returns and should be purchased with the understanding that they should produce returns likely greater that a pure fixed annuity but substantially less than equity market returns.
Fixed index annuity interest is calculated using a formula that determines how much of that percentage change in the index applies to the account value of the fixed indexed annuity. Insurers use a variety of calculation methodologies for these formulas including those involving participation rates, caps, and spreads to limit the amount of interest that can be credited based on the change in value of the underlying stock market index. It is critical that the consumer fully understand how interest will be earned and credited to their fixed index annuity contract as part of the purchase process.
These contracts appeal to retirees and pre-retirees who want to conservatively participate in potential market appreciation with downside principal protection.
Immediate Income Annuities
An immediate income annuity guarantees payments, which can start right away, for a period of time (called a period certain) or for the annuitant’s life. The payments made can be fixed (e.g., $600 per month) or variable (increasing 3% per year) based on the consumer’s selection.
Here is how they work. In exchange for a lump sum premium, the life insurer guarantees to make regular income payments until death, or for a specified period of time, typically starting one to twelve months after receipt of the premium. Immediate annuity payments are typically higher than other annuities because they include a return of the buyer’s principal, as well as interest, and also offer favorable tax treatment.
In almost every case, once a consumer purchases an immediate income annuity, it is an irrevocable decision between the purchaser and the insurance company and cannot be voided. If the immediate income annuity was purchased with after-tax dollars, each payment received will be part return of principal and part interest. So, a portion of each payment will not be taxable. The percentage that is not taxable is called the exclusion ratio.
These are popular among retirees and pre-retirees who use the payments to supplement their income and are comfortable sacrificing principal in exchange for guaranteed income.
Deferred Income Annuities and QLACs
A deferred income annuity (DIA) is an annuity contract between you and a life insurance company. You make a lump-sum payment to the insurance company in exchange for guaranteed lifetime income that begins at a future date, up to forty years later in some cases. These products are sometimes referred to as “longevity annuities” because the income stream can be triggered so far in the future. Many people use them to protect against running out of income should they have very long lifespans. Deferred income annuities work similarly to immediate annuities, except that the payments don’t start immediately.
With deferred income annuities, you shift the risk of outliving your income to the insurer, who promises to pay you a certain amount of income for the rest of your life beginning at the age you elect. The insurer also assumes your interest and market risk; even if the market and interest rates go down significantly during your deferral period, you still get the same guaranteed payment amount. In short, the investment risk and the interest rate risk during the deferral period are assumed by the issuing life insurance company.
In exchange for assuming these risks, deferred income annuity contracts are irrevocable, meaning they have no cash surrender value, and no cash withdrawals are permitted. Their purpose is to provide income in later life to protect against longevity risk. Effectively you are granted a guaranteed income payment in the future if you live that long.
As with all fixed immediate annuities, the rise and fall of the stock market or interest rates does not affect the amount of future income you will receive from your deferred income annuity. When you sign the contract, you decide when you want to start receiving income and the insurance company will guarantee you a set income. Most deferred income annuities allow for subsequent contributions to your contract, but the way these subsequent deposits are factored into future income varies from one product to another. It often depends on the frequency of the subsequent contributions.
It cannot be stressed enough that deferred income annuities are not liquid, and you have little ability to no ability to get access to the cash you invested in the contract. When you invest in a deferred income annuity, you completely forfeit the initial premium in exchange for the insurance company’s promise to pay you in the future. There are several products that have some liquidity options; however, they can be difficult to invoke and are often subject to surrender fees.
Deferred income annuity products appeal to people who want guaranteed income in the future, not now, or who want to create a ladder of income over different periods later in life. For example, they may want to work in retirement but know that they will eventually stop working and, at that point, and not before, will need guaranteed income from an annuity.
QLACs – A Special Type of Deferred Income Annuity
A QLAC is a deferred income annuity that allows withdrawals from certain types of qualified accounts to begin beyond age 72 without conflicting with required minimum distribution (RMD) rules. QLACs provide the owner with flexibility to defer the income start date until age 85. They can only be funded, however, with assets from a Traditional IRA or with assets from an eligible employer-sponsored qualified plan including a 401(k), 403(b), or governmental 457(b).
Similar to other deferred income annuity contracts, QLACs are irrevocable, have no cash surrender value, and no withdrawals are permitted. Their purpose is to provide income in later life to protect against longevity risk.
These products are designed and have been approved by the Internal Revenue Service to offset the risks of aging. It is important to understand that the IRS has placed limits on how much money can be invested in QLACs, and you are ultimately responsible for ensuring that you meet applicable rules. These limits change periodically.
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.