Annuity. When you hear that word, some people have a reaction.

Sometimes it’s a positive reaction, or it may be a negative reaction. However, that reaction is biased. It’s biased towards annuities. 

As I get into this, we’re going to explain the different types of annuities and where that bias comes from. 

That’s not as important for us to just talk about it because we are all biased in different ways, shapes, or fashions. A bias isn’t necessarily good or bad. It might be based on our experience or what we have known, and it may or may not even be true.

We have biases to many things, sometimes good, sometimes bad, sometimes neutral.  

There is a bias that black people tend to be more athletic and have better rhythm, which I know in our family this is true!

We may think that Asians are better at math and science.

We all have different biases in different ways, but one way or another, it doesn’t mean that the bias is good, bad, right, or wrong or that there’s even any prejudice in it. 

It’s just biased. It’s how we feel.

We may be biased on where we eat, which restaurants are best, or what cars we drive. 

I know that some people are biased towards Ford, and others say they only like Chevy.

We could go on and on, right? It is just something that is human and that we all have. We are all biased in some way.

With that in mind, let’s get back to the annuity. When you hear the word annuity, do you have a reaction? Sometimes we see that people have a bias one way or another towards not just annuities, but any investments.

The thing that’s important to do is to make sure that a bias is accurate so that you are not keeping yourself from something that could help your financial portfolio or help you reach your financial dreams.

What Are The Different Types Of Annuities?

So let me talk about the different types of annuities. An annuity is an investment vehicle offered by insurance companies.

We can have cars, trucks, vans, or an SUV. Just like there are many different types of vehicles, there are also different types of annuities.

I want to take a minute and explain it because I think it helps if we really understand where that is. 

If you do have a bias, maybe you’ve shut your mind off to some of the other available options. You may also be reading this thinking, I don’t even know what an annuity is. That’s okay too, because this will be good information for you.

A few terms that you’re going to hear when talking about annuities is immediate or deferred.

Immediate Annuities

The other type of annuity is an immediate annuity. This is actually the first type of annuity that I want to talk about. You don’t have the deferral because an immediate annuity starts paying you an income stream immediately.

This type of annuity pays an immediate amount of money. You might hear this and think of a pension. A pension is paid through an immediate annuity. It’s a set amount of income either for a specific period of time or for life.

I haven’t talked to one person who doesn’t like a pension or doesn’t wish they had a pension. Therefore, most people like immediate annuities from that perspective.

You could take the money that you saved, put it into an immediate annuity, and create income from it. That was a strategy that we’d used more in the past, before some of the other great income tools came out.

If you put your money in an immediate annuity, you cancreate an income. The highest income option is lifetime only. This means that as long as you are alive, you will get income.

However, if something happened and you got in an accident and then ended up passing away a few years later, then there’d be nothing left for the beneficiaries.

This scenario can be upsetting, but remember that the purpose of those immediate annuities is to get the most amount of income possible. 

When a company does that, it’s not that they’re keeping the rest of the money; they will pool it to distribute to the others who outlive the average life expectancy. While some people pass young, others will live longer.

Deferred Annuities

Most annuities are deferred annuities. What that means is that once you invest in an annuity, you don’t have to pay taxes on the money. That means that it’s tax-deferred. 

If you have an IRA or Roth or anything, that’s the driver of the vehicle, and it’s already going to be taxed the way the driver says. 

Let’s just say you had money that you saved outside of a retirement plan. This is considered non-qualified. It doesn’t belong to an IRA or Roth. If you put it in an annuity, then the taxes are deferred, and you don’t pay the taxes on the gains until you take them out.

3 Types of Deferred Annuities.

Variable Annuities

Variable annuities tend to have higher costs associated with them, starting with the M&E (mortality and expense) fees.

The M&E fee covers the guarantee of a death benefit, ensures income cannot be outlived once annuitized, and guarantees that certain expenses will not increase.

Let’s say that you put $100,000 into a variable annuity and it’s down to $70,000. If something happened to you, the beneficiaries would get $100,000. This is what the M&E fee covers.

However, if the $100,000 grows over $100,000, the account value is the basic death benefit, but the M&E fee is charged on the account balance, so you end up paying higher fees for no real benefit.

Sometimes there is an enhanced death benefit, but that will come with an additional fee.

Annuitizing means turning the lump sum into an immediate annuity as detailed above. There are sometimes enhanced income benefits as well, but again, those also come with additional fees.

There is also a surrender fee, which all annuities will have if you withdraw more than the free withdrawal amount during the surrender years, normally 3-7 years for a variable annuity.

Variable annuities are invested in different sub-accounts or mutual funds and are subject to market volatility.

This is an annuity that we often find that people have this prejudice about because they knew somebody who had this type of annuity, and it was down, so they were losing money, but they felt they couldn’t get out because of the surrender fees.

We don’t like variable annuities. We feel you should either commit to a time or take a risk to make money, but not both, which is what a variable annuity does. Plus, the high fees are not worth the benefits in most cases.

Fixed Annuities

Fixed annuities pay a fixed rate like a CD for a fixed period of time.

Usually, it’s going to be a little longer term, maybe three to five years, or even seven years. Also, the rates are a little higher.

The return is usually 1.5% to 2% higher than you’d get on a CD. 

Fixed Index Annuities

With this annuity, you have to remember the term fixed. (We also call this “green” money)

Instead of giving you a fixed rate, they’re going to take what they would have given you in a fixed rate and use it to link returns to one of the major indexes, like the S&P 500. 

The gains are based on the performance of that index. If the index goes up, you receive returns up to a cap or a percentage of the total return. If the index goes down, you receive 0%, you didn’t make anytihing but you didn’t lose anything. In this way, zero is your hero.

This is possible because your money is in secure, fixed investments paying a fixed rate of return. The company takes their operating costs out of that and then uses the rest to give you a fixed rate of buy options into an index. That is why there are caps on the earnings as well as no market losses.

Index annuities can also come with additional riders, income riders, enhanced death benefits, and sometimes even long-term care riders. Any rider comes with a cost; otherwise, there are no management fees associated with index annuities.

With anything, it is a matter if the benefit or the value is worth the fee. Income riders can guarantee a higher return for income and then guarantee income for life or joint life, like an immediate annuity, but without losing access to the lump sum. When higher income is needed, or guaranteed income is desired, these riders are a great way to create your own personal pension.

Are Annuities Good? What About Surrender Charges?

There are two ways to make money. Commit to a time, or take a risk. With a fixed or fixed index annuity, you’re committing to a time.

There is downside market risk, but there is a surrender charge period that goes down each year for a set period of time. 

For a fixed annuity, it might be 2-10 years, for an index annuity, the average is 10 years. 

What does that look like?

If you put $100,000 in a mutual fund, can you tell me what’s the least amount you could take out, the worst-case scenario, in five years?

You can’t, because it depends on what’s going on in the market. If there were a 30% market downturn, you could have $70,000 or less in that mutual fund. There is no bottom dollar. 

Now, lets like at the worst case with an indexed annuity.

If the market were down every year for five years, you would still have $100,000, they don’t participate with market downturns. 

If you had a 10-year index annuity with a surrender charge that started at 10% and went down 1% each year, in the fifth year would be 5%. 

If you surrendered the contract, you would receive $95,000. You know your bottom line always.*

When you think about it that way, those surrender charges aren’t bad; they are just different. There are surrender periods because the company is buying long-term fixed-rate investments to secure your account, and they lose if money is withdrawn early. However, they do give you a penalty-free withdrawal amount each year, normally 10%, and there are no surrender charges upon death at anytime.

(*Note, with a variable annuity, you have both market risk and surrender charges, so this scenario is only for fixed index annuites with no market adjustment)

Do I Need An Annuity?

Annuities, just like any investment, need to fit with your overall goals.

If income guarantees are important, annuities are a great option.

If principal protection is important, then fixed or fixed index annuities are a great option. 

But you don’t have to take my word for it.

David Babbel, a professor and PhD, conducted a study on index annuities and found the returns to be better than the alternatives. 

Another professor and investment officer, Roger Ibbotson, conducted a study on using fixed index annuities as an asset class. 

The U.S. Treasury recommends that retirees get an annuity for the ability to guarantee income.

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