The more I write about annuities, the more questions I receive about them. One thing that’s become obvious is that many investors are confused about the differences between the various types of annuities.
Let’s start at the beginning.
An annuity is a contract with an insurance company in which you agree to pay the insurance company an amount of money (a “premium”), and they agree to make payments to you of a specified amount, with a specified frequency, for a specified period of time.
Lifetime vs. Specific Period
Many annuities are lifetime annuities, which means that the period in question is the rest of your life. For example, the insurance company promises to pay you $1,000 every month until you die.
Other annuities are joint lifetime annuities, or simply joint annuities, whereby the insurance company promises to pay a certain amount every period until both you and the other annuitant (usually your spouse/partner) have passed away.
Finally, some annuities aren’t lifetime annuities at all. They simply pay out for a fixed number of years, at which point the payments stop. For example, you could purchase a 3-year annuity that would make payments every month for 3 years.
Note that an annuity with a fixed period is different from a bond. Bonds pay interest over their life and return the principal to you as one lump-sum at maturity. With an annuity, the principal is returned over the life of the annuity.
For the most part, when I write about annuities, I’m referring to lifetime annuities. Their promise to provide income for as long as you live makes them unique — they protect against longevity risk in a way that no other investment does.
Fixed Annuities vs. Variable Annuities
Fixed annuities pay a fixed amount over the life of the annuity. Note: The fact that an annuity is a fixed annuity doesn’t necessarily mean that its payout never changes. You can buy fixed annuities with payouts that increase at a given rate each year — say, 3% — or that increase in keeping with inflation.
Variable annuities are essentially an insurance product wrapped around a portfolio of mutual funds. They typically promise to pay a fixed amount each period, with the potential for that amount to ratchet upward if the underlying mutual funds perform well.
Generally speaking, I’m not a huge fan of variable annuities. They’re usually complex and expensive, and because they each tend to offer different bells and whistles, it’s difficult to compare them to see which provider offers the best deal.
In contrast, fixed annuities are easy to understand and easy to compare. For example, when shopping for a fixed lifetime annuity, if two different insurance companies have similar credit ratings, just go with the one that provides a higher payout for a given premium.
Immediate Annuities vs. Deferred Annuities
With an immediate annuity, the insurance company begins sending you checks immediately after you pay the premium.
With a deferred annuity, there’s a delay between the time at which you pay the premium(s) and the time at which the insurance company begins to send you checks. For the most part, unless you’ve maxed out your retirement accounts and are looking for additional means of tax-deferred saving, there aren’t too many cases in which deferred annuities make sense.
Single Premium Annuities vs. Multiple-Premium Annuities
With a single premium annuity, the premium is a single lump-sum. You write one check to the insurance company, and they start making payments to you at the agreed-upon date.
Other annuities require you to pay premiums over a period of time. For example, you might pay a premium every month until age 65, at which point you stop making payments and the insurance company starts making payments to you.
That’s Just the Beginning
The above descriptions are only a starting point — they don’t even come close to covering every single type of annuity out there. For example, there are several sub-categories of variable annuities. And within the category of fixed annuities, there’s a whole range of additional features (“riders”) you can add to the contract.
In my opinion, the one annuity that every investor should understand (not necessarily buy, but at least understand) is the single premium immediate fixed lifetime annuity. I know that sounds like a mouthful, but based on the terminology above, you can tell that such an annuity would involve:
- You making a single payment to the insurance company, and
- The insurance company making fixed payments to you (or, if you prefer, payments that increase with inflation) for the rest of your life.