There are three types of annuities: fixed, variable and indexed.
Fixed Annuities
With a fixed annuity, the insurance company guarantees both the rate of return (the interest rate) and the payout to the investor. The interest rate on a fixed annuity can change over time. Often the interest rate is fixed for a number of years and then changes periodically based on current rates. Payouts can be for an entire lifetime, or you can choose another time period.
With a deferred fixed annuity, the insurance company agrees to pay you no less than a specified rate of interest during the time that your account is growing. With an immediate fixed annuity—or when you "annuitize" your deferred annuity—you receive a predetermined fixed amount of money, usually on a monthly basis (similar to a pension). These payments may last for a specified period, such as 25 years, or an unspecified period such as your lifetime or the lifetime of you and your spouse.
The predictability of a fixed annuity makes it a popular option for investors who want a dependable rate of return and the option to begin a guaranteed income stream to supplement their other investment and retirement income. Fixed annuity payouts aren’t affected by fluctuations in the market, so they can provide peace of mind for investors who want to ensure that they will have a predetermined amount of money to carry them through retirement and cover identified future expenses.
Variable Annuities
Variable annuities offer investors choices among a number of complex contract features and options. With variable annuities, the rate of return—and therefore the value of your investment—might go up or down depending on the performance of the stock, bond and money market funds that you choose as investment options.
Variable annuities are sometimes compared to mutual funds because they offer similar investment features, including investment choices—called "subaccounts"—that resemble mutual funds. However, a typical variable annuity offers three basic features not commonly found in mutual funds:
- tax-deferred treatment of earnings;
- a death benefit; and
- annuity payout options that can provide guaranteed income for life.
While a variable annuity has the benefit of tax-deferred growth, its annual expenses are likely to be much higher than the expenses of a typical mutual fund. And, unlike a fixed annuity, variable annuities don’t provide any guarantee that you'll earn a return on your investment. Instead, there’s a risk that you could actually lose money.
Variable annuities generally offer death benefits, meaning that if you die before the insurance company has started making payments, a designated beneficiary will receive a specified amount. However, unlike a term life policy, where the beneficiaries in most instances receive more than the premiums made, beneficiaries of variable annuities are generally only guaranteed a return of the premium, net of any withdrawals. For an additional fee, you may purchase a death benefit rider that can increase the death benefit based on market performance or a fixed rate.
In general, variable annuities have two phases: 1) the "accumulation" phase, when the premiums you pay are allocated among investment portfolios, often referred to as subaccounts, and your earnings on these investments accumulate; and 2) the "payout" phase, when the insurance company guarantees a minimum payment to you based on the principal and investment returns (positive or negative).
Due to the complexity of variable annuities, they’re a leading source of investor complaints to FINRA. Before buying a variable annuity, carefully read the annuity’s prospectus, and ask the person selling the annuity to explain all of the product’s features, riders, costs and restrictions. You should also know how your broker is being compensated, including whether they’re receiving a commission and, if so, how much.
You can check whether your broker is licensed or has a history of complaints by going to FINRA's BrokerCheck.
Indexed Annuities
Indexed annuities are complex financial instruments that have characteristics of both fixed and variable annuities. Indexed annuities typically offer a minimum guaranteed interest rate combined with an interest rate linked to a market index.
Many indexed annuities are tied to broad, well-known indexes like the S&P 500 Index. But some use other indexes, including those that represent other segments of the market. Indexed annuities expose you to more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity.
Understanding the features of an indexed annuity can be confusing. There are several indexing methods firms use to calculate gains and, because of the variety and complexity of the methods used to credit interest, it’s difficult to compare one indexed annuity to another.
Indexed annuities are generally categorized as one of the following two types:
- Equity-Indexed Annuities (EIAs) – EIAs offer a guaranteed minimum interest rate (typically at least 87.5 percent of the premium paid at 1 to 3 percent interest), as well as an additional interest rate tied to the performance of one or more market index. Generally, when investing in an EIA, your principal is guaranteed, but your interest rate, which includes the market-linked component, is not.
- Registered Index-Linked Annuities (RILAs) – RILAs, sometimes referred to as “buffer” annuities, also credit your investment with an interest rate tied to one or more market index. Depending on the RILA, you select either a buffer or a floor, which limits exposure to losses but often caps your opportunity for gains by the same amount.
A buffer represents the percentage loss of your chosen market index(es) that you select to have the insurance company absorb before you absorb losses in excess of that percentage. For example, if your selected buffer is 10 percent and the market index decreases by 15 percent, you only absorb a 5 percent loss.
A floor represents the percentage loss of your selected market index(es) that you’re comfortable absorbing before the insurance company absorbs losses in excess of that percentage. For example, if your selected floor is 10 percent and the market index decreases by 25 percent, your maximum absorbed loss is 10 percent.
Further, features such as buffers and floors may change over time, and you can experience losses if you withdraw money early.
Before purchasing an indexed annuity, make sure you understand not only each feature, but also how the features work together. This combination can have a significant impact on your return. You can also use BrokerCheck to find out whether the person selling a RILA is registered with FINRA.