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Retirement Planning > Retirement Investing > Annuity Investing

What You Need to Know About Annuity Classes

By John Olsen, Michael E. Kitces

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Classifying things into types is always a tricky business. Consider a red Chevrolet Corvette.

What is it?

Well, that depends upon the type or types of classifications we’re using. It’s a motor vehicle. But what kind of motor vehicle? Well, it has four wheels, so that we can use that classification to make clear that it’s not a motorcycle (which uses two or three wheels). It’s also a car (as opposed to a truck). And a kind of car called a sports car as opposed to, say, a station wagon. (Are there still station wagons?) And this one is red, so it’s not blue or black or some other color.

The problem with assigning only one category to anything is that readers sometimes think that this fully describes that thing. But it never does. The car in question is a car and a sports car and red and a Chevrolet (it’s not a Ford or any kind of foreign car) . . . We mention this because annuities are complex because there are several different types and subtypes, designed to do very different things. Understanding that any one annuity contract may be described accurately by several different labels is essential to an understanding of how it works. So, let’s get started.

It is possible to divide all annuity contracts into different types using four different parameters:

1.    How is the annuity purchased?

2.    When do regular annuity payments are commence?

3.    How are contract values and premiums invested?

4.    How is the contract taxed?

1. How Is the Annuity Purchased?

Using this parameter, there are two kinds of annuity contracts: (1) Single Premium, and (2) Flexible Premium.

A single premium annuity is a contract purchased with a single payment, or premium. No further premiums are required, or even allowable. By contrast, a flexible premium annuity is purchased with an initial payment (to establish the contract) and allows for a series of premiums that may be paid whenever, and in whatever amount, the purchaser wishes, subject to policy minimums and maximums.

2. When Do Regular Annuity Payments Commence?

Using this parameter, there are three kinds of annuity contracts: (1) the Immediate Annuity, (2) the Deferred Annuity, and (3) the Deferred Income Annuity (DIA), sometimes called the Longevity Annuity.

An immediate annuityis one in which regular income (annuity) payments must be made to the owner commencing within one year of purchase. (Insurance companies will usually agree to issue annuity checks directly to a nonowner annuitant if requested to do so by the owner, but the tax liability will be the owner’s). Other labels sometimes used to describe an immediate annuity are payout annuity or income annuity.

A deferred annuityis one in which annuity payments may be deferred until later than one year after purchase—perhaps much later. The life of a deferred annuity is divided into two phases:

A third type of annuity (using the parameter of “when annuity payments begin”), often called a longevity annuity,first appeared in the marketplace in 2007. It is similar to an immediate annuity in that it provides only for income (usually for life); there is no accumulation period. Unlike an immediate annuity, the longevity annuity income does not commence within one year of purchase; rather, it is deferred on until a future date, which is typically an advanced age such as age eighty-five.

3. How are the Contract Value and Premiums Invested?

Using this parameter, there are two types of annuity contracts: (1) Fixed, and (2) Variable.

Fixed Annuities

A fixed annuity (either Immediate, Deferred, or Deferred Income) is an annuity in which the contract value is measured in dollars. A variable annuity (either Immediate or Deferred) is one in which the contract value is measured in terms of units—either accumulation unitsor annuity units, depending upon whether the contract is in the accumulation phaseor the distribution phase. The value of both units can, and probably will, vary each business day, according to the investment performance of the separate accounts (or “investment subaccounts”) chosen by the contract owner.

4. How Is the Contract Taxed?

Using this parameter, there are two kinds of annuity contracts: “qualified” and “nonqualified.”

The first term refers to contracts that are purchased by employer-sponsored retirement programs such as a 401(k) plan. Contributions to and distributions from such plans are subject to special tax rules (which vary somewhat with the type of plan). “Nonqualified” annuity contracts, by contrast, are purchased with “regular”, nondeductible dollars outside of these retirement plans.

Chart of Annuity Types

The chart below shows the types of annuities organized in terms of when income may or must commence.

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