Types of Annuities

Types of Annuities A Fast Guide to Deciphering Annuity Choices

If you’re looking for a guaranteed income in retirement, then you may be researching various annuity options to determine what the best solution may be. While everyone’s dream of the ideal retirement is different, there is one commonality among all retirees – it takes a steady stream of income to make it happen. Over the past decade or so, though, the way retirees receive their income has changed. For instance, with the disappearance of many employer-sponsored pension plans, along with a shaky Social Security program, more people have to create their own “personal pension plans” – and annuities can allow you to do that. That’s because an annuity can generate an ongoing and reliable stream of income – and with the lifetime annuity income option, you can alleviate the concern about running out of money when you need it. But with so many different options available in the annuity marketplace, how do you know which one may be right for you? This guide will help you to narrow it down.

Important Annuity Terms to Understand

The financial services world is filled with jargon and terms that can sometimes make even the simplest concepts confusing. With that in mind, before you commit to an annuity, there are some important annuity terms to understand.

1035 Exchange – If you already own an annuity, you may be able to swap it for a different annuity that better fits your objectives. This may be done tax-free through a 1035 exchange transaction.
Accumulation Value – This refers to the total current value of a fixed annuity. It includes all of the contributions you have made to the annuity and the accumulated interest earnings, minus any fees and prior withdrawals – but before any surrender charges are factored in.
Annuitant – The annuitant is the individual (or individuals) upon whom the annuity contract is based. An annuitant is also the person who receives income from an annuity.

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Annuitization – Annuitization is defined as converting an annuity’s account value into a guaranteed stream of income over a set period of time or even for the remainder of the annuitant’s lifetime.
Beneficiary – The beneficiary is an individual or entity that is named in the contract to receive the annuity’s benefits if the annuitant passes away. There can be more than one beneficiary named.
Cap – Used with fixed indexed annuities, a cap is the maximum amount of interest that is credited to the account in a given time period. For example, if an annuity has a cap of 5%, and the underlying market index is tracking returns 7%, then the annuity will be credited with 5% for that time period.
Contract Anniversary – The contract anniversary on an annuity is the anniversary of the initial issue date.
Death Benefit – If an annuitant passes away, a death benefit may be paid out to a named beneficiary (or more than one beneficiary). Unlike a life insurance death benefit, annuity death benefits are not income tax-free.
Deferred Annuity – With a deferred annuity, one or more contributions can be made over time. The growth inside of the account is allowed to accumulate tax-deferred. The annuity can be converted to an income stream at a date in the future.
Deferred Income Annuity (DIA) – Also referred to as a longevity annuity, a deferred income annuity (DIA) provides an income stream at a future date – in some cases, up to 30 or 40 years after the annuity is purchased. Because of this, the income payout can be quite a bit higher than that of a regular deferred annuity.
Exclusion Ratio – The exclusion ratio is the percentage of an annuitant’s return that is not subject to tax upon withdrawal.
Fixed Annuity – A fixed annuity provides a set interest rate that the offering insurance company sets. These financial vehicles allow you to grow your funds on a tax-deferred basis. They can also provide you with a guaranteed income for life.
Fixed Indexed Annuity – A fixed indexed annuity, or FIA, generates its return based on an underlying market index’s performance, such as the SP 500. These annuities provide the opportunity to earn a higher return than that of a regular fixed annuity while also keeping your principal safe – even in a down market.
Flexible-Premium – Flexible premium annuities allow contributions to be made at later dates once the annuity has been set up and an initial premium paid.
Free Look Provision – Annuity purchasers, will typically have between 10 and 30 days (depending on their state of residence) after the annuity has been delivered to them to determine whether they want to keep it. If they do not, they can receive a full refund of their premium.
Guarantee Period – The time frame during which an issuing insurance company’s interest rate will be guaranteed.
Guaranteed Minimum Surrender Value – This refers to the minimum amount in an annuity that the owner is guaranteed to receive if they surrender the contract, minus any market value adjustments (MVAs) and surrender charges.
Hybrid Annuity – Hybrid annuity is a term that is used to describe a fixed indexed annuity (FIA) that includes an optional income rider attached to it.
Immediate Annuity – With an immediate annuity, income will begin right away (or within 12 months of purchase). This income can be paid for a set period of time, such as 10 or 20 years, or for the remainder of the annuitant’s lifetime.
Income Rider – Income riders are optional enhancements that can be added to an annuity – typically for an additional premium charge – and that can help to generate a higher amount of income in the future.
Joint Annuitant – A joint annuitant and a primary annuitant can both receive income from an annuity. Oftentimes, partners or married couples will opt for the joint and survivor income option on annuities in order to ensure that both will have income for the remainder of their lifetimes.
Life Annuity – Life annuity refers to an income payment option that continues to pay income to the recipient for as long as he or she is still alive.
Market Value Adjustment (MVA) – If an annuitant withdraws more than the penalty-free amount (usually more than 10% of the contract’s value) during the surrender period, an adjustment of the interest rate may be made. Depending on whether interest rates have gone up or down since the annuity’s initial purchase, the rate could be higher or lower following the market value adjustment.
Multi-Year Guarantee Annuity (MYGA) – MYGA annuities are a type of fixed annuity that allow you to lock in a set rate for a certain period of time.
Non-Qualified Annuity – A non-qualified annuity is one that is purchased using after-tax dollars (as versus with pre-tax funds, like those that are contributed to a traditional IRA or 401k plan).
Premium – An annuity’s premium consists of the total collective contributions that are made, minus any of the earned interest.
Qualified Annuity – A qualified annuity is purchased with pre-tax dollars, such as those that contribute to a traditional IRA or 401(k) plan.
Renewal Rate – An annuity’s renewal rate is the interest rate that is offered by the insurance carrier on an in-force fixed annuity once the initial guarantee period has ended.
Rollover – Rollover is a term that refers to the moving of tax-qualified funds from one IRA or retirement plan to another without incurring tax consequences. A rollover can help to maintain the tax-deferred status of the funds.
Single-Premium Immediate Annuity (SPIA) – A single premium immediate annuity, or SPIA, is an annuity that, in return for one lump sum contribution, provides a guaranteed income stream for a certain period of time, or even for the lifetime of the annuitant.
Surrender Charge – Also often referred to as a withdrawal charge, this is a penalty that the insurance company imposes if an annuity is terminated (i.e., surrendered) or more than the penalty-free amount is withdrawn during the surrender period. (Typically, up to 10% of the contract’s value may be withdrawn penalty-free during the surrender period).
Variable Annuity – Variable annuities generate their returns based on the performance of underlying investments such as mutual funds. While variable annuities can offer the opportunity for nice growth, they can also be risky if these investments perform poorly.
Yield – Yield refers to the total average annual interest rate percentage that is earned with a fixed annuity during a specific time period. Premium bonuses and interest rate enhancements are included in the determination of the yield.

The First Step When Choosing an Annuity

Before committing to any type of financial tool or retirement planning services, it is necessary to determine what goal (or goals) you are trying to achieve. For instance, is your intention to fill an income “gap” between your future retirement income and expenses? Or are you looking for a way to continue generating tax-advantaged savings while at the same time keeping your principal safe? Annuities can provide you with a way to accomplish all of these options. But not all annuities can provide you with a solution for all objectives. That’s why it is also important to know what types of annuities are available, as well as the various ways of “customizing” an annuity so that it best meets your specific needs.

There are several different types of annuities. These include:

Fixed Annuities
Market Value Adjusted Annuities
Indexed Annuities
Variable Annuities

Fixed Annuities A fixed annuity offers a set amount of interest that is typically credited on an annual basis. The growth in the account is tax-deferred, meaning that no tax is due on the gain until the time of withdrawal. Fixed annuities are known for providing principal protection in any type of market environment. They can also pay out a reliable stream of income for a certain period of time or even for the remainder of your lifetime. There are actually several varieties of fixed annuities. These include regular fixed annuities, fixed indexed annuities, and multi-year guarantee (MYGA) annuities. While all of these annuities guarantee that your principal will remain safe, the way your return is tracked can differ. For example, a multi-year guarantee annuity, or MYGA, allows you to lock in a rate for a set period of time, such as 3, 5, 7, or even 10 years. Once that time period has elapsed, you typically have the opportunity to renew at the then-current rate(s), or instead to withdraw your money from the annuity penalty-free. Market Value Adjusted Annuities Many fixed and multi-year guarantee annuities (MYGAs) can include a “market value adjustment” that allows the issuing insurance carrier to give you a higher rate of return than regular fixed annuities in return for passing along some – or even all of the risk if you cash out of the annuity early (i.e., before the end of the surrender period). For instance, if you take “too much” (usually more than 10% of the contract’s value) out of the annuity before the surrender period has elapsed, your account value can be adjusted. In this case, if interest rates have gone down since you originally purchased the annuity, your rate will be adjusted upward. However, if rates have gone up since you purchased it, the interest rate on your MYGA annuity will likely be decreased. As with other types of annuities, MYGA annuities allow tax-deferred growth in the account. They can also pay out an ongoing income stream for a set time period, such as 10 or 20 years, or for life.
Indexed Annuities An indexed annuity earns interest and provides a return based on an underlying market index, such as the SP 500 or the Dow Jones Industrial Average (DJIA). With a fixed indexed annuity, the positive return may be “capped” at a certain amount – even if the index performs well within a given time period. However, if the index performs poorly, the annuity will be credited with a 0% for that period rather than with a loss. These annuities also offer a guaranteed minimum rate, which typically runs between 0% and 2%. In addition, indexed annuities allow for tax-deferred growth to take place in the account, and they can offer a variety of different income options if or when you are ready to “annuitize” the contract.
Variable Annuities Variable annuities offer the opportunity to take advantage of market-related gains because the returns are based on the performance of underlying investments, such as mutual funds. Your money is not invested directly into the stock market but rather in the issuing insurance company’s “sub-accounts.” It is important to keep in mind that while variable annuities can provide higher returns than fixed or fixed indexed annuities, there is also the possibility of loss if the tracked investments perform poorly. These annuities are known for having high fees, including money management charges on each of the individual investments the annuity is tracking. There can also be optional rider fees if you choose to add additional features to the annuity. Variable annuities are considered securities. So, you must be presented with a prospectus if a retirement financial advisor offers you a variable annuity. Like other annuities, the growth that takes place in a variable annuity is tax-deferred.

Do You Need Income Now or Income Later?

In addition to being fixed, indexed, or variable, annuities can be either immediate or deferred. Because of that, you can choose an annuity that best matches up with your immediate or future income goals. For example, with an immediate annuity, you can contribute one lump sum and then begin to receive income right away (or typically within 12 months of purchasing the annuity). Many retirees choose to purchase immediate annuities because they can “rollover” funds from retirement accounts like a 401(k) or IRA and then start to receive income from these savings. Deferred annuities allow you to contribute either one lump sum or multiple premium payments over time. The income stream with a deferred annuity can begin at a time in the future – and, depending on the annuity, it could be 30 or 40 years before income begins. Deferred annuities have two specific phases – the accumulation phase and the distribution phase. During the accumulation phase, funds that are in the account can grow on a tax-deferred basis. So, if you’re not planning to retire for several more years, a deferred annuity can help you to continue growing your savings in a tax-deferred manner. A deferred annuity can also provide some investors with an additional option for growing savings on a tax-advantaged basis – even if their annual contributions to other tax-deferred accounts have been “maxed out.” Deferred annuities may offer some additional benefits, too, such as penalty-free access to funds if you are diagnosed with a terminal illness or you need to reside in a skilled nursing home for a certain period of time. There is also oftentimes a death benefit associated with these annuities so that a named beneficiary can receive the remainder of your contributions if you pass away prior to getting the full amount back. There is some amount of liquidity with deferred annuities, as well. You can take out up to 10% of the contract’s value in many cases even during the annuity’s surrender period. (If you withdraw more, though, you will incur a surrender penalty – and, if you are under the age of 59 when you make a withdrawal, you could also have to pay an additional 10% early withdrawal penalty to the IRS).

Annuity Income Options

Regardless of when you begin taking your income payments from an annuity, you will typically have several options to choose from while financial planning for retirement. These can include the following:

Period Certain – As its name suggests, the period certain income option will pay out over a set time frame, such as 10 or 20 years. Once the time period has elapsed, the payments from the annuity will stop. If the income recipient (annuitant) dies before the end of the stated time period, the income will continue to be paid to a beneficiary until the time is up.
Life Only – The life-only option will continue to pay income for the remainder of the annuitant’s life. This is the case no matter how long he or she may live. So, this option can eliminate the worry about running out of money in retirement for those who live a long life.
Life with Period Certain – This income option offers a “combination” of the period certain and the life only alternatives in that it will continue paying income for the remainder of the annuitant’s lifetime. But, if they pass away within a set period of time, such as 10 or 20 years, the payments will continue to be made to a named beneficiary.
Joint and Survivor – The joint and survivor option is often used by married couples or partners who want to make sure that both individuals will continue receiving an income for the rest of their life. (Depending on the particular annuity, the dollar amount of the income may either stay the same or be reduced upon the death of the first annuitant).

Additional Options to Help Customize Your Annuity

In addition to an income stream and tax-deferred growth, annuities may offer additional benefits, as well. These may include:

Death Benefit – Many annuities offer a death benefit provision whereby if the income recipient dies before they receive back all of their contributions, a death benefit will be paid to a beneficiary. It is important to note that unlike the death benefit from a life insurance policy, annuity death benefits are typically not income tax-free.
Nursing Home / Terminal Illness Waiver – Some annuities may also include terminal illness or nursing home waivers where funds can be accessed penalty-free in the event that you are diagnosed with a terminal illness, or you must reside in a nursing home for at least a certain amount of time, such as 90 days.
Income Riders – Some annuities can have an income rider attached (usually in exchange for an additional premium). These riders can help to solve longevity risk by providing the annuitant with a lifetime income stream. In addition, income riders may also have a growth rate that is guaranteed. (It is important to note that the growth rate on an annuity income rider is not the same as the return on the annuity’s contract, or account, value).

Annuity Charges and Fees

Although most investment vehicles contain some sort of fees, annuities have garnered a reputation for having exorbitant charges. This, however, is not necessarily the case. Knowing the type(s) and amount of annuity fees can help you anticipate them and avoid them in some cases. Different types of annuities will typically have different costs. For instance, the more “moving parts” an annuity has, the higher the expenses will typically be. With that in mind, fixed annuities usually cost less than variable or indexed annuities. One reason for this is because fixed annuities are relatively simple products that are not linked to investments or underlying market indexes. Some of the more common fees that you may find on annuities include:

Commissions – Although all annuities have sales commissions, in many cases, these charges are actually built into the price, so they are not highlighted in the contract. Overall, annuity commissions can run between 1% to 10% of the total contract value, depending on the type of annuity you are purchasing.
Rider Charges – If you opt to place an additional rider on an annuity, you may have to pay an additional amount of premium.
Mortality Expenses (ME) – If there is a death benefit on a variable annuity, the charge for this could range between 0.5% and 1.5% of the policy’s value each year.
Investment Expense Ratio – Variable annuities track underlying investments via the insurance carrier’s sub-accounts. These will typically require an investment management fee that may range between .25% and 2% of the account’s value, and these fees are charged each year.
Administrative Expenses – Many variable annuities will also charge an administrative or admin fee to cover the cost of ongoing services and mailings. These fees can oftentimes range between .10% and .30% of the contract’s value, and they are charged on an annual basis.

Most all annuities have surrender charges. This refers to a fee that you are charged if you take money out of an annuity within a certain period of time that is known as the withdrawal or the surrender period. Typically, surrender charges will start out at a certain percent, and then gradually grade down over time, until they eventually disappear. In most cases, you can withdraw up to 10% of the annuity contract‘s value each year, penalty-free, even during the surrender period.

Annuity Surrender Charge Example

Contract Year 1 2 3 4 5 6 7 8 9 10 11+ SurrenderCharge Percent 9 9 8 7 6 5 4 3 2 1 0 Oftentimes, the surrender charge on a multi-year guarantee annuity (MYGA) will correspond with its interest rate guarantee period. (And sometimes, if you choose to re-invest for another guarantee period after the first one has elapsed, the surrender period could re-set).

MYGA Annuity Surrender Charge Schedule

Year: 1 2 3 4 5 6 7 8 9 10 11+ 5-yr rate guarantee 9% 8% 8% 7% 6% 0 7-yr rate guarantee 9% 8% 8% 7% 6% 4% 4% 0% 10-yr rate guarantee 9% 8% 8% 7% 6% 4% 4% 3% 2% 1% 0%

Taxation of Annuity Income

The way your annuity income is taxed will depend on whether the annuity is qualified or non-qualified. A qualified annuity is funded with pre-tax dollars. Some examples include money that is rolled over from a traditional IRA or 401(k) plan where your contribution has not yet been subject to income taxation. In this case, if none of the funds in the annuity have yet been taxed – including the tax-deferred gain – then 100% of your future payments will be taxable as ordinary income. A non-qualified annuity is one that was funded with after-tax dollars. For instance, you may have funded the annuity with dollars from personal savings or a checking account. With non-qualified annuities, your income payments will consist partly of taxable gain, and in-part a return of your non-taxable contribution. The percentage of your return that is not subject to tax is referred to as the exclusion ratio. If you make withdrawals from an annuity before you are age 59 , you could also incur an additional 10% “early withdrawal” penalty from the IRS. So, it is important for you to time your annuity withdrawals to pay the least amount of taxes and penalties and net more spendable income in your pocket.

What Type of Annuity is Right for You?

Everyone’s financial goals are different. So, to determine the best annuity for you, it is essential first to outline your short- and long-term financial objectives and decide what you want the annuity to do for you. Knowing what you can anticipate in terms of your annuity’s performance can be another key factor in whether or not it is the best choice for you. Likewise, be sure that you research the insurance company that you’re considering buying an annuity. That way, you can get a better idea of its financial strength and stability, as well as its claims-paying reputation. To help you determine this information, you can check the ratings that the insurer has received from A.M. Best, Standard Poor’s, Moody’s, and / or Fitch Ratings. Because annuities have many “moving parts,” it is best to discuss your potential options with an annuity planning professional or retirement income specialist. That way, you can together narrow down the right annuity for your specific needs.