The three main types of annuities: what they are and how they work
Every day we expose ourselves to risk: getting out of bed, doing yard work or going to work. However, we can potentially mitigate those risks by using caution and having insurance.
Do we face risks when planning for retirement? Absolutely! And like auto or health insurance, annuities can help eliminate the uncertainty of retirement by guaranteeing a lifetime stream of income.
Types of Annuities
For retirement-minded individuals, annuities have several attractive features that may be worth exploring. Three main types of annuities are:
- Fixed multiple-year guaranteed annuity or MYGA
- Fixed-indexed annuity
- Variable annuity
There are two additional versions, immediate and deferred annuities, based on the timing of the payouts.
Let’s take a closer look at each type of annuity.
Fixed multiple-year guaranteed annuity or MYGA
A fixed multiple-year guaranteed annuity or MYGA is the simplest of the three options. This annuity:
- offers a fixed rate of return for a set period;
- provides stability of principle, a degree of liquidity, is tax-deferral and requires minimal fees (typically only a surrender charge during the contractual period);
- most guarantee their rates for three to seven years.
When the contractual period is over, you can withdraw the funds penalty-free. However, if you take possession of the funds and don’t move them to another annuity, you’ll pay taxes on the interest earned. Historically, fixed annuities have offered higher rates than certificates of deposit or CDs.
In 2008, interest rates for bonds, CDs and savings plummeted when the Federal Reserve implemented its quantitative easing policy. To no surprise, fixed annuity rates dropped too. Annuity companies began to offer opportunities to get a higher rate of return with no downside risk through fixed-indexed annuities, which link the rate of return to certain stock indexes like the S&P 500.
Here’s how it works: The insurance company offers a return up to a certain limit called a cap if the index has a positive return. For example, if the cap on the S&P 500 was 4% and the S&P 500 returned 6.5%, the insurance company will credit a 4% return to the policy that year. If the S&P 500 increases 2%, the policy will be credited 2%.
In return for the reduced participation in the market upside, the annuity provides downside protection in negative years. Although the annuity doesn’t lose value, it doesn’t gain anything either. Fixed-index annuities can provide higher returns than their fixed counterparts, but it’s not guaranteed.
Most variable annuities offer mutual fund-like subaccounts that invest in stocks and/or bonds. The subaccounts offer investment objectives like mutual funds, and they range from income-focused to aggressive growth. Variable annuities will offer a wide variety of subaccounts for every investor.
The primary benefit of a variable annuity is tax-deferral. However, because they are provided by insurance companies, they’ll sometimes offer a death benefit at a cost. Death benefits vary based on the company and product. Some insurance companies offer the highest anniversary value, while others will return all premiums paid if there’s $1 in the contract on the day of death. Other variable annuities offer a Guaranteed Minimum Income Benefit or a Guaranteed Lifetime Withdrawal Benefit to provide retirement income options that you cannot outlive.
Is it the right fit for me?
Why should someone consider purchasing an annuity? As mentioned above, if you’re looking for a secure place for a portion of your funds, fixed and fixed-index annuities may provide a reasonable opportunity for growth.
If you’re planning on retiring soon, you should consider an annuity for a different reason. The paramount purpose of an annuity – any annuity – is to provide a guaranteed lifetime income. Although not all annuities are used for income, they’re all created for it.
An Old National Investments financial advisor can help you determine if this strategy is right for you.
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 1/2 are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.
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