An annuity is a financial instrument that can be used for creating a long-term savings or retirement plan. Basically, the term “annuity” refers to the contract that you enter into with an insurance or finance company in which you agree to make a series of payments that will eventually be returned to you at some point in the future.
What are the Different Types of Annuities?
There are several different types of annuities. The two major categories are broken down by how quickly they pay out: immediately versus on a deferred basis. These two major categories are then further divided into five main ones, which will be discussed in detail below.
Deciding which one to choose will depend on a number of factors, such as how quickly someone wants to be paid out, their income goals, how willing they are to take risks, and so forth. As with most things, each one comes with its own advantages and disadvantages, and may differ depending on what the insurance or finance company is offering as part of their contract terms.
Generally speaking, the following is a list of the five main types of annuities:
- Fixed annuities: Fixed annuities are typically issued by insurance companies, as opposed to financial firms. They are structured to provide a standard rate of interest, are relatively low cost, and are useful for persons seeking a predictable source of income for when they retire. There are usually no fees for fixed annuity plans and they are the simplest to comprehend out of the five listed here.
- Variable annuities: In contrast to fixed annuities, variable annuities will not pay out every year. Instead, the money will be invested into various mutual funds and securities, which will be managed by the insurance company. Although these can be structured with an attached rider that states the person can receive a fixed stream of income, they are typically formed without the rider and based on the stock market. Thus, the amount disbursed will fluctuate.
- These are also associated with the highest fees, may have penalties for early withdrawal, and do not pay out regularly.
- Fixed-Indexed annuities: These are a combination of the two just discussed. They provide a minimum standard income, but they also generate a fluctuating rate of interest based on stock market indices, such as the S&P 500. However, there is usually a cap on how much the person can receive if the market index performs well. Thus, what could be a high return under variable annuities, will be capped here. There also may be fees.
- Immediate annuities: Immediate annuities offer the highest payouts. They operate similarly to life insurance policies. Basically, how this works is that the person will hand over a large lump sum payment, which will then start to distribute about a year later. These work best for persons willing to sacrifice funds up front and looking for a high income stream later in life. Also, there are usually no fees associated with them.
- Deferred annuities: Deferred annuities delay disbursements until over a year has passed. There are average fees attached to them and are usually offered by insurance companies. They also happen to be cheaper overall since the insurance company will not have to immediately return any payments. The downside here is that the person will have to wait until they start generating an income stream.
What are Some Disadvantages of an Annuity?
An individual may come across several problems with annuities. While the advantages and disadvantages to annuities may depend on the individual and the annuity option they choose, there are several overall issues that often arise with annuities. This may include:
- In the event of an emergency or other immediate need, a person will not have access to all of their money. Thus, even with an immediate annuity, a person cannot simply request to have all their money returned. Also, if it is one of the plans that has timed disbursements, then there will be high fees or penalties associated with any withdrawals that are made before they are due.
- There are also significant commission fees and ongoing investment management fees associated with all annuities. Those must be paid on a continuous basis until the plan is terminated or some other circumstance cancels the contract.
- For the annuities that are capped or issue a portion to the insurance company for management fees, the individual is not reaping the benefits they could get if they entered the stock market on their own. However, this also means that their losses are not as high either.
- Although there is no tax imposed while the annuity is accruing money, the money being disbursed will be taxed at a considerably high rate.
Who Can Sell Annuities?
As discussed above, annuities can be purchased from either an insurance company or a financial investment firm. Annuities are typically regulated by two federal agencies: the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Thus, regardless of whether the seller is an agent of the insurance company or financial firm, they must possess a license to sell annuities.
Some examples of places to purchase annuities from include:
- Brokerage firms;
- Independent brokers or agents;
- Financial advisors;
- Large banks; and
- Mutual fund firms.
In addition, it is very important that an individual seeking to purchase annuities conduct substantial research on the companies and/or individuals with whom they plan to do business. Word-of-mouth referrals, online reviews, and trustworthy authorities (e.g., attorneys or accountants) are wise ways to vet a company or to get referrals to a good company before purchasing annuities.
Who Can Buy Annuities?
Realistically, anyone who wishes to purchase an annuity can go ahead and buy one. However, they are much more useful and prudent for some people over others.
For instance, one type of individual who may want to consider purchasing an annuity is a defendant to a personal injury case. The payouts can be used to pay off a judgment or to make settlement arrangements with the plaintiff to the case.
Another person who may want to invest in one is someone looking to retire or that needs long-term care due to illness. The annuity provides a stream of income for them instead of having to work.
On the other hand, someone who is young and healthy may be better off with investing directly with the stock market since they can still work and may not be able to make up-front, lump sum payments yet.
What are the Different Types of Payout Options?
As previously discussed, the two major categories of annuities are based on how they are paid out: immediate versus deferred payments. A person who opts for an immediate plan must pay a certain lump sum amount up front. This means that they will lose a large amount of money at first, but in return, will have a steady, immediate, and long-lasting stream of income to retire on.
On the other hand, if a person chooses one of the deferred payment options, then they need to select a date for when their payments should start. This date will then become part of the contract terms. As they make payments, the annuity will start to earn interest over time. Also, so long as the annuity is continuing to earn interest, it will remain untaxed. However, if a person requests to take the money out before it is due, they will be penalized.
Additionally, once the money begins to be disbursed from a deferred payment annuity, the interest will be taxed.
What Happens to My Annuity If I Die?
If the individual with the annuity becomes deceased before it pays out, then one of two things may happen. First, the beneficiary may assume or take over their payments, meaning they will be responsible for the terms of the contract until the full annuity is reached and can be paid out. If they do not wish to take over payments, then the second option they have is to receive whatever the current cash value is of the annuity.
However, sometimes the beneficiary will not have an option because the contract will usually state which one will occur upon death of the annuity holder. Therefore, it is very important to read the terms of an annuity contract before signing and before requesting a pay out.
When Do I Need to Hire an Attorney for Annuity Issues?
Although you do not necessarily need an attorney to set-up the annuity, it can be useful to consult one when you are deciding which type of annuity would best accomplish your goals and realistically be tailored to your situation. Thus, if you are considering entering into an annuity arrangement, then you should contact a local business lawyer for further advice.
Additionally, you may want to consider hiring a business or annuity lawyer if there is a dispute over the annuity with the insurance company and you have to appear in court. One conflict that frequently arises in connection with annuities is non-payment in accordance with contract terms.
An attorney who has experience with annuities will be well-versed in the terminology, how annuities work, can review the terms of your contract, and will know which laws are relevant and apply to your matter. They also will be able to represent you in court.