Different Types of Annuities Explained

Educational PurposeAnnuities may be classified in two main ways: when income begins (immediate or deferred) and how value or interest is determined (fixed, fixed indexed, variable, or registered index-linked). Understanding both classifications is important because two annuities may share the same general name while having very different guarantees, risks, fees, liquidity provisions, and income options.

1. Immediate Annuities

An immediate annuity is generally purchased with one lump-sum payment, and income normally begins within one year of purchase.

The purchaser selects an available payout option, such as:

• Income for one lifetime.
• Joint income for two people.
• Income for a fixed number of years.
• Lifetime income with a guaranteed payment period.

The payment amount may depend on the purchase amount, age, interest-rate assumptions, the number of people covered, and the beneficiary protection selected.

Possible advantage

An immediate annuity may convert part of a person’s savings into predictable income relatively quickly.

Important trade-off

After the purchase amount is converted into an income stream, access to the original lump sum may be limited or unavailable. Some income elections may be irrevocable.

Questions to ask

• When will payments begin?
• Are payments guaranteed for life or for a fixed period?
• Is the payment amount fixed or variable?
• What happens at death?
• Can the decision be reversed?
• Will any cash value remain accessible?

2. Deferred Annuities

A deferred annuity is designed for benefits that begin at a future date.

It may be funded through:

• One purchase payment.
• Several scheduled payments.
• Flexible contributions, when allowed by the contract.

During the accumulation period, the contract may receive interest credits or investment-related gains or losses according to its terms. Income or withdrawals may begin later.

Possible advantage

A deferred annuity provides time for the contract value or income benefit to develop before retirement income begins.

Important trade-off

Deferred annuities are generally long-term contracts. Withdrawals during the surrender period may result in surrender charges, taxes, possible tax penalties, or reductions in future benefits.

Questions to ask

• How long is the surrender period?
• How is growth determined?
• What amount may be withdrawn without a surrender charge?
• What fees or adjustments apply?
• When may income begin?
• What happens after an excess withdrawal?

3. Fixed Annuities

A fixed annuity credits interest according to guarantees and rates established by the insurance company and described in the contract.

A contract may provide:

• A guaranteed minimum interest rate.
• A declared rate that applies for a stated period.
• Renewal rates determined by the insurer.
• Fixed-income options at a future date.

The insurer generally guarantees principal and credited interest according to the contract, subject to withdrawals, charges, and the insurer’s claims-paying ability.

Possible advantages

• Easier to understand than many market-linked contracts.
• Protection from direct stock-market losses.
• Predictable interest-crediting provisions.
• Potential future income guarantees.

Important limitations

• Renewal rates may be lower than the initial rate.
• Long-term returns may not keep pace with inflation.
• Withdrawals may be restricted.
• Surrender charges or market-value adjustments may apply.
• Guarantees depend on the issuing insurer.

Questions to ask

• How long is the initial rate guaranteed?
• What is the guaranteed minimum rate?
• How are renewal rates determined?
• Is there a market-value adjustment?
• What is the surrender schedule?
• Which amounts are guaranteed?

4. Multi-Year Guaranteed Annuities

A multi-year guaranteed annuity, commonly called a MYGA, is a type of fixed deferred annuity that provides a stated interest rate for a defined number of years.

For example, a contract may guarantee a rate for three, five, or seven years. At the end of the guarantee period, the owner may have several options under the contract, such as renewal, withdrawal, exchange, or conversion to income.

Possible advantage

The owner knows the stated credited rate for the selected guarantee period.

Important limitations

• Access may be restricted during the term.
• Surrender charges may apply.
• Renewal terms may differ.
• Taxes or penalties may apply to distributions.
• The contract is not the same as a bank certificate of deposit.

A MYGA is an insurance-company contract, and its guarantees depend on the issuing insurer rather than federal bank-deposit insurance.

5. Fixed Indexed Annuities

A fixed indexed annuity is a type of fixed annuity whose credited interest may be linked partly to the performance of a market index.

The owner does not directly own the stocks or other assets included in the index. Instead, the insurer uses a contract formula to determine whether interest will be credited.

The calculation may involve:

• A participation rate.
• An interest cap.
• A spread or margin.
• A floor.
• A specific crediting method.
• An index term or measurement period.

Example of a cap

When an index rises by 10% but the contract has a 6% cap, the credited interest may be limited to 6%, subject to the complete contract formula.

When the index declines, the contract may credit zero interest for that period rather than apply the full index loss. However, withdrawals, surrender charges, rider fees, and market-value adjustments may still reduce contract value.

Possible advantages

• Protection from direct index losses under the contract’s crediting provisions.
• Potential to earn more interest than a conventional fixed annuity.
• Optional future-income features.

Important limitations

• The owner does not receive the index’s full return.
• Dividends may not be included.
• Caps, spreads, and participation rates may limit interest.
• Crediting terms may change when the contract permits.
• The calculations may be difficult to compare.
• Long surrender periods may apply.

Indexed annuities generally involve more return uncertainty than traditional fixed annuities but less direct market risk than variable annuities.

6. Variable Annuities

A variable annuity combines an insurance contract with investment options, commonly called subaccounts.

The contract value may increase or decrease based on the performance of the selected investment options. This means the owner can lose money, including principal.

Variable annuities may also provide:

• Tax-deferred accumulation.
• Death-benefit provisions.
• Annuitization options.
• Optional lifetime-income riders.
• Other guarantees available for additional charges.

Possible advantages

• Greater potential for market-based growth.
• Choice among available investment options.
• Optional insurance and retirement-income features.
• Tax deferral on earnings until distribution.

Important limitations

Variable annuities may include several layers of cost, such as:

• Mortality and expense charges.
• Administrative fees.
• Investment-option expenses.
• Rider fees.
• Surrender charges.
• Transfer or transaction charges.

The contract value may fluctuate, and optional guarantees may apply only when detailed contract requirements are followed.

Questions to ask

• What are the total annual costs?
• Which investment options are available?
• Can principal be lost?
• What does each rider cost?
• What happens after an excess withdrawal?
• How long is the surrender period?
• How does the death benefit work?

Variable annuities are securities as well as insurance products and are subject to securities regulation.

7. Registered Index-Linked Annuities

A registered index-linked annuity, often called a RILA or buffered annuity, is a security whose returns are linked to an index under a contract formula.

Unlike many fixed indexed annuities, a RILA may expose the owner to a portion of market losses.

The contract may offer limited downside protection through a:

• Buffer, under which the insurer absorbs a stated portion of a decline.
• Floor, which may limit losses to a stated maximum.

In exchange for this limited protection, growth may be restricted through caps, participation rates, or other contract provisions. RILAs are securities and may involve investment risk, including loss of principal.

Simplified buffer example

Suppose a contract has a 10% buffer.

• When the selected index falls 7%, the buffer may absorb that decline.
• When the index falls 18%, the owner may experience an 8% loss.

The actual result depends on the complete contract formula, fees, index term, withdrawals, and other provisions.

Questions to ask

• Does the contract use a buffer or a floor?
• What losses remain the owner’s responsibility?
• What cap or participation rate limits gains?
• How long is each index term?
• What happens when money is withdrawn before the term ends?
• Can the rates or limits change?

8. Income Annuities and Longevity Annuities

An income annuity is designed primarily to provide scheduled payments rather than long-term cash accumulation.

A longevity annuity is generally purchased around retirement, but payments begin at a much later age. Its purpose is to help address the financial risk of living significantly longer than expected.

Possible advantage

Delaying the start date may allow the contract to provide a larger future income payment relative to the amount allocated.

Important limitations

• Income may not begin for many years.
• Access to the purchase amount may be limited.
• Death-benefit provisions may vary.
• Inflation may reduce future purchasing power.
• The income promise depends on the insurer.

9. Qualified and Nonqualified Annuities

Annuities may also be described according to the type of money used to fund them.

Qualified annuity

A qualified annuity is held within a tax-advantaged retirement arrangement or funded with qualified retirement money, such as money from certain workplace plans or individual retirement accounts.

Distributions are generally taxable according to the rules governing the retirement account and the funding source.

Nonqualified annuity

A nonqualified annuity is generally purchased with money that has already been taxed.

The earnings may grow tax-deferred, but taxable gains are generally subject to income tax when distributed.

The word qualified does not describe the quality of the annuity. It describes its tax status.

Tax treatment can be complex, particularly for withdrawals, annuitization, exchanges, inherited contracts, and early distributions. A qualified tax professional should review the individual circumstances.

10. Comparison Overview

No category is automatically best. The appropriate comparison depends on:

• The purpose of the money.
• Time horizon.
• Need for liquidity.
• Desired income start date.
• Tolerance for market risk.
• Need for guarantees.
• Inflation concerns.
• Beneficiary goals.
• Fees and surrender provisions.
• Other available retirement income.

11. Questions to Ask Before Comparing Contracts