There are many different types of annuities available in the marketplace today. These include immediate and deferred, as well as fixed, indexed, and variable. When the payments begin, and how the return is calculated, can depend on these variations.
For instance, immediate annuities start to pay out income right away (or within 12 months of purchase). A deferred annuity, on the other hand, can pay income, too. But it doesn’t start until a time in the future.
Immediate versus Deferred Annuities
How much income you receive from an annuity can depend on the annuity type, as well as other criteria such as the length of the income payment term, and the interest rates offered by the insurance company.
For example, fixed deferred annuities offer a stated rate of return that is set by the insurance company, regardless of what happens in the stock market. While the return on fixed annuities is oftentimes low, these types of annuities keep your principal protected.
Because of this protection, these particular financial vehicles are oftentimes attractive to those investors and retirees who are seeking safety and predictability, as well as certain types of guarantees.
Fixed-indexed annuities are a type of fixed annuity. However, these annuities base their return on the performance of one or more market indexes, such as the S&P 500 or the Dow Jones Industrial Average (DJIA).
When the performance of the underlying index during a given contract year is positive, the fixed indexed annuity will be credited with a positive return, usually up to a certain limit, or “cap.”
But, if the performance is negative, the annuity will not lose value. Rather, it is credited with a guaranteed minimum “floor” amount, which can usually range from 0% to 2%. So, even if the underlying index suffers a substantial loss, the principal in the annuity is protected. Because of that, fixed-indexed annuities are oftentimes said to offer a “best of both worlds” scenario.
Variable deferred annuities offer the opportunity to generate a higher return than a fixed or fixed-indexed annuity. That is because the funds in a variable annuity have their return tied to the performance of underlying equities such as mutual funds.
In this case, there is oftentimes no upper limit – or “cap” – that is imposed on the gain (like there is with a fixed-indexed annuity). So, there is the potential for a significant amount of growth in the variable annuity contract.
However, there is also the risk of loss if the underlying investments perform poorly. Therefore, variable annuities may not be a good option for those who are seeking protection of principal and/or for retirees who are looking for specific income guarantees, like the ones offered on fixed and fixed-indexed annuities.
It is also important to note that if you own an annuity in a retirement plan, such as an IRA, it is considered a qualified annuity, whereas one that you have in a personal, non-retirement account, is known as a non-qualified annuity.
How is Annuity Income Determined?
With an annuity, the income payments are calculated using several different factors when you go to turn on the income stream. These include the:
- Number of payments or length of payment term. In this case, a shorter payment period, such as 10 years, would pay a higher dollar amount on each individual payment than one with a 20-year payout term. The lifetime income option typically pays the lowest dollar amount per payment. However, this alternative can ensure that income will arrive for as long as you need it.
- Interest rate. The insurance company determines the interest rate on annuity payments. A lower rate will result in a lower dollar amount of payment.
- Amount of principal. The amount of money in the account when you annuitize (i.e., convert the annuity to a payment stream) is another key factor for determining how much your annuity income payments will be. In this instance, the larger the income “base,” the higher the individual income payments will be.
While fixed and fixed indexed annuities can provide you with the same dollar amount of payment throughout the payment period, the amount of income from a variable annuity could differ from one period to another.
Also, many annuities allow you to add inflation protection whereby the amount of the income payment increases over time. In this case, though, the initial dollar amount may start out lower than it would with the fixed payment option.
With that in mind – and because not all annuities are the same – it is recommended that you discuss your financial objectives, risk tolerance, time frame, and other factors with an annuity specialist before making a long-term commitment.