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Retirement Planning > Spending in Retirement > Income Planning

Cheat Sheet: Basic Annuity Types and Facts Every Advisor Should Know

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What You Need to Know

  • Annuities can be pretty basic: a lump sum and then payments for life. But new products abound.
  • Anuities are sold by insurance companies, so make sure the company is fundamentally sound.
  • Riders, such as to deal with inflation or death, can be added to annuities for extra fees.

Annuities are becoming more accessible through fee-only advisors and retirement plans. For advisors who have clients interested in these products, here’s a quick rundown on what types of annuities are available and how, generally, each type works.

Keep in mind: There are always new wrinkles to think about. If you are new to annuities, and you want to explain them to clients, start by talking to your compliance people, to see what kinds of training and advisory support you need. Also, remember, this is just a basic cheat sheet to get you started.

Let’s start with some basics:

  1. Annuities need a solid foundation: Annuities are products sold by insurance companies, and the contracts typically stay in place for many years, or even for a lifetime. The key is to make sure the company is fundamentally sound.
  1. All U.S. retail annuities have key similarities: 1) The annuity is a contract between your client and the insurance company; 2) Money in the account grows tax-deferred, until it’s withdrawn (unless bought with after-tax funds); and 3) annuities provide periodic payments over a specific time, for life or in lump sums.

2 Main Types of Annuities

Fixed: This refers to the size of a payout. These are annuities in which a minimal rate of interest is guaranteed, and periodic payment amounts do not fluctuate. These are the simplest, have lower payouts than other annuities and typically don’t have fees, but do have surrender charges.

Variable: Variable annuities include a separate account where money is typically invested in mutual funds. Payouts can vary depending on the performance of these underlying investments. Variable annuities carry the greatest risk (client could lose principal), but could have higher payouts. Also, fees can be high.

2 Main Types of Annuity Payout Options

Deferred: This refers to when payouts begin. In this case, payouts are delayed until a future date. This gives money in the account time to grow. During this accumulation phase, no taxes are paid. There are some fees.

Immediate: In this case, payouts begin shortly after you make a lump-sum payment to the insurance company, and once this happens, principal can’t be withdrawn.

Retail Annuity Types

Contingent Deferred Annuity (CDA): This is a new concept in which an annuity is “bolted onto” a client’s portfolio. The cost varies according to fluctuations in the stock market. A CDA on a portfolio with higher stock allocation would cost more than one with lower allocations to stocks. 

Multi-Year Guaranteed Annuity (MYGA): This is a type of fixed annuity designed to protect the premium and accumulate interest at a guaranteed rate for a specific amount of time, typically a period of three to 10 years.

Non-Variable Indexed Annuity: This is a type of annuity that that offers a guaranteed minimum rate of at least 0%, meaning that the the holder cannot lose account value due to poor investment market returns. The holder can then earn additional interest, based on the performance of one or more investment indexes, such as the S&P 500. State insurance regulators classify these contracts as non-variable, or fixed, because of the guaranteed minimum rate of return.

Registered Index Linked Annuity (RILA): These have grown popular in recent years. A RILA limits exposure to downside risk and provides the opportunity for growth. It offers more growth potential than a fixed indexed annuity but less potential return, and less risk, than a variable annuity. Typically these products offer a variety of term lengths.

Qualified Longevity Annuity Contract (QLAC): This is an annuity that is purchased with retirement account funds and held within a traditional retirement plan — whether it’s a 401(k), 403(b) or traditional IRA. Annuity payments are deferred until the client reaches old age to provide retirement income security late in life (generally no later than age 85). This also is a way to hedge against or reduce required minimum distribution as it drawn down a retirement portfolio. Many 401(k)s may not allow QLACs to be purchased within the plan but the clients are able to roll distributions over to IRAs.

Single-Premium Immediate Annuity (SPIA): This contract will pay out immediately or within a year after a single, lump-sum purchase. SPIAs can be paid out on a monthly, quarterly or yearly basis. Interest rate returns on these products often are higher than certificates of deposit.

Traditional Fixed Annuity: This product provides an interest rate that is guaranteed one year at a time, as well as an ongoing guaranteed rate. It allows the purchaser to not only guarantee a rate yearly but to lock in upswings in interest rates.

Available Features

Free-look period: Many U.S. states require insurance companies to include a “free-look” period that allows a buyer to cancel the contract without incurring a surrender charge.

Riders: These are addendums to the contract that allows for customization. For example, there are inflation riders, or more well utilized are death-benefit riders that ensure a beneficiary receives a portion of the contract value after the client dies. Riders typically incur an extra fee.

Tax deferral: Annuities allow clients to reduce their taxable income when buying an annuity with pretax funds, and clients won’t be taxed until they withdraw the amount. If an annuity is purchased with after-tax money, only the earnings will be taxed when the money is withdrawn. Most states charge insurance companies a premium tax, which typically is passed on to the consumer, but some, including California and Florida, charge a tax on annuities.

Spousal coverage: Often called a joint and survivor annuity, this allows a client to buy a product that will pay for them or their spouse for the lifetime of whoever lives longer.

Fine Print

Buyers and their advisors should understand these issues: 

  1. Liquidity: Clients who put cash in an annuity typically face a surrender period of two to 10 years. They will pay a surrender charge if they remove the money or cancel the contract before then. Some other types of annuities, such as immediate annuities, may not have surrender charges but may not allow the client to withdraw lump sums.
  2. Cost: Fees on these products vary. Insurance-based annuities can charge fees for add-on benefits, and variable annuities can charge both benefit and annual maintenance.  Variable annuity issuers may charge many different amounts, such as general fees or administrative fees, mortality and expense risk expenses, investment fund expenses and distribution charges.
  3. Complexity: A common complaint is that annuities can be complicated. Remember that these products typically are designed based on the assumption that a licensed agent or advisor will help the client understand the nuances, not for clients who will shop on their own.
  4. Stability: Advisors working in this area need to know how insurer ratings work and have some ability to form their own independent views of insurance company strength.

Note: Here’s an annuity glossary that can help advisors and clients better understand annuities.

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