Annuities, Part 3: Types of Annuities

Annuities are complicated. This article should help you understand the most common types of annuities and how they are described. 

I’ll start with what I think is the most simple type of annuity to understand, and work my way down to what I believe is the most complex. By the end, the phrase “non qualified flexible premium deferred equity indexed annuity” will actually make sense.

Let’s get to it.

Types of Annuities

First, let’s define what an annuity is. The SEC, FINRA, and the NAIC all have very similar definitions of an annuity. I’ll quote the SEC’s: 

“An annuity is a contract between you and an insurance company that is designed to meet retirement and other long-range goals, under which you make a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments to you beginning immediately or at some future date.”

In essence, you give some money to an insurance company, and they give you money back. That sounds pretty simple, but as we’ll find out, there are many “flavors” of annuities, each which their own unique twists.

1. Single Premium Immediate Annuity (SPIA)

SPIAs are also referred to as “income annuities.” Conceptually, they are pretty simple. You give a lump sum of money to an insurance company, and in return, they give you a regular “paycheck.” With immediate annuities, the paychecks usually begin within 30 days. In real life, they look something like the graph below.

This is slightly oversimplified because there are still some choices you need to make.

  • Flat vs. Increasing Payments: Some annuities will let you choose if you want to receive flat payments, or  payments that steadily increase. Note that you don’t get the increases for free, since your first payment will usually be smaller than if you choose the flat option.
  • Timeframe: You can also choose how long you want the payments to continue. You can choose for your lifetime, or your spouse’s lifetime. You can also choose a fixed number of years, if you wish.

2. Deferred Income Annuity (DIA)

DIAs are also referred to as “longevity annuities” and a particular type of DIA you may have heard of is a Qualified Longevity Annuity Contract (QLAC).

They function very similarly to SPIAs, but with 1 key difference. Instead of your payments starting right way, they start years after you make your contribution. In return for waiting, the regular payments you receive will usually be larger than if you had chosen a SPIA. In real life, they look something like the graph below.

You usually have some flexibility over how long you wait until your payments begin. And like SPIAs, you usually have flexibility over flat vs. increasing payments, and the time horizon for your payments will last.

3. Single Premium Deferred Fixed Annuity

This next type of annuity adds a layer to our previous understanding by introducing an account balance. 

The “single premium” means you make one lump sum contribution, and the “deferred” means you don’t start receiving payments right away. The “fixed” means that your contribution will grow at a fixed rate for a time horizon that is usually specified in the annuity contract.

The graph below helps visualize this. The red and green bars represent cash flows (deposits and payments), and the yellow line represents the account balance.

You can see that the lump sum deposit gets put into an account, and that account grows at a steady rate. Then, when you want to begin receiving regular payments, you can “turn your income on” by annuitizing. When you annuitize, you are giving the insurance company the money in your account balance, and in return, they promise to give you regular payments.

Technically annuitizing is optional with this type of annuity. Unlike SPIAs and DIAs, where annuitizing is mandatory, you don’t need to annuitize a deferred fixed annuity. 

While the account is growing, it’s considered to be in the accumulation phase. If you choose to annuitize, it will flip from the accumulation phase to the annuitization phase, which is when you will be receiving regular payments.

4. Flexible Premium Deferred Fixed Annuity

These annuities are the same as single premium deferred fixed annuities, except instead of making only 1 lump sum contribution, you make multiple contributions over time. It looks like the graph below.

Again, your money will grow at a fixed rate for a certain period of time. Then at some point in the future, you can choose to annuitize your money and begin receiving regular payments. As before, annuitization is optional.

5. Variable Annuity (VA)

VAs work similarly flexible premium deferred fixed annuities. The only difference is that the growth in your account balance isn’t a fixed, guaranteed rate. 

Instead, you choose investments, called “sub accounts” within your account balance. Your growth will depend on how well the investments perform. Notably, if the investments lose money, you will lose money also. So variable annuities are riskier than fixed annuities. The graph below should help visualize.

Again, annuitization is optional. If you do annuitize, you may choose between a fixed payment and a variable payment.

6. Fixed-Indexed Annuity

The final, and in my opinion most complicated type of annuity to understand, is a fixed-indexed annuity. These are also called “equity-indexed annuities” or just “indexed annuities.”

Fixed annuities have a guaranteed growth rate. Variable annuities have a growth rate that fluctuates with the investments and can be positive or negative. Indexed annuities are like a combination of both. Let me explain.

The investment growth of an indexed annuity is tied to a market index, ie the S&P 500®. If the index goes up in value for the year, your investments will have positive growth. However, you likely won’t get 100% of the growth, because most indexed annuities have caps/participation rates that limit the growth in any single year. Basically your upside is capped.

However, if the index is negative for the year, you won’t make any money, but you also won’t lose any money. You essentially have a “floor” where the growth can never be below 0%. So indexed annuities give you some (not all) of the upside, but none of the downside. The graph below helps you understand. 

Your growth will never be negative, but you also won’t “knock it out of the park” when the market is doing very well.

Again, if you choose to annuitize, you can usually choose between fixed and variable payments.

Ways to Classify Annuities

As you can see, there are many types of annuities, and many ways to classify them. Once you learn to “speak their language” you’ll actually find annuities much easier to understand.

1. Timing: Immediate vs. Deferred

Will you begin receiving payments right away, or at some point in the future?

2. Contributions: Single Premium vs. Flexible Premium

Will you contribute money in one lump sum, or make regular contributions over time?

3. How it Grows: Fixed vs. Variable vs. Indexed

If the growth rate fixed, variable with investment performance, or tied to an index?

4. Account Type: Qualified vs. Non Qualified

Is the annuity held inside a retirement account, or held outside a retirement account?

Now, when you read “non qualified flexible premium deferred equity indexed annuity” you know:

  • The annuity is held outside a retirement account.
  • You can make ongoing contributions to it.
  • You will receive payments at some point down the road.
  • The investment growth is tied to an investment index.

It’s important to point out that not all statements or annuity descriptions list out all of these adjectives. So sometimes you have to do some research.

Conclusion

Whether you are considering purchasing an annuity, or just trying to better understand one you already own, learning the types of annuities and how to classify them can help.

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