How to Choose the Best Annuity for Retirement


After choosing to invest in an annuity for a continued source of retirement income, the decision then becomes the type of annuity to choose.  Many people are left with more questions than answers.

How Annuity Premiums are Invested

There are three types of annuities where premiums are invested:  a fixed interest annuity, variable annuity, and indexed annuity.  Depending on retirement goals and income needs, choosing the correct type of annuity is important.

Fixed Interest Annuities

A fixed interest annuity pays a fixed rate of interest on the premiums stated in the contract, minus any stated charges.  The insurance company guarantees that it will pay a minimum interest rate for the entire life of the annuity contract.  An insurance company may also pay a bonus interest rate, which is guaranteed for a shorter period, such as one year.  However, with this option, the interest rate may also be subject to higher fees which will reduce or even eliminate the value of the bonus interest rate.

Within the fixed interest annuity family, there are two types of fixed interest annuities:  Deferred and immediate fixed annuities.

  • Deferred Fixed Interest Annuities – Premium payments are purchased with either a single premium or through a series of installment premiums.  A fixed rate of interest is paid during the accumulation phase and determined by the insurance company and stated in the contract.  Once matured, the value of the annuity can be received in a lump sum or a fixed, level of set payments that will not end during the life of the annuity holder.
  • Immediate Fixed Annuities – A single premium purchases an immediate fixed annuity.  The single premium is turned into a series of fixed income payments that begin immediately after the premium is paid.  

Variable Annuities

During the accumulation phase of a variable annuity, premiums are placed in a separate account of the insurance company.  The annuity owner can then invest in one or more stock and bond subaccounts.  During the income phase of a variable annuity, the amount of each income payment may be fixed and guaranteed, or it may be variable.  The amount changes with the value of the investments in the separate account.

Just as fixed interest annuities have both deferred and immediate options, variable annuities offer the same type of options.

  • Deferred Variable Annuities – Purchased with a single premium or with a series of installments, a deferred variable annuity’s accumulated funds are placed in a separate account of the insurance company.  The owner can invest them in one or more subaccounts.  Consisting of stocks, bonds, money market instruments, and other types of investments, the value is not guaranteed, but rather varies according to the performance of the subaccounts selected by the annuity owner.  On the start date of the annuity, a single lump sum or fixed and guaranteed payments can be received.
  • Immediate Variable Annuities – Purchased with a single premium, an immediate variable annuity begins to pay immediately.  These payments will increase or decrease depending on the investment results chosen by the annuity owner.

Indexed Annuities

The most complex of the annuity options, the indexed annuity features options from both a fixed interest and a variable annuity.  Comparable to a variable annuity, the insurance company pays a rate of return on annuity premiums that is directly linked to a stock market index, such as the Standard & Poor’s 500 Composite Stock Price Index.  Similar to fixed interest annuities, indexed annuities also offer a minimum guaranteed interest rate.  This means that the risk risk of loss of principal is less than with variable annuities.

An investment in an indexed annuity is not a stock market investment.  Instead of purchasing one or more stocks, the rate of return is linked to the performance of an overall market index that follows the performance of a certain group of stocks. Since the minimum guaranteed interest rate is combined with this interest rate linked to a market index, indexed annuities have the possibility to earn returns superior to fixed interest annuities when the stock market is rising.  

With increased returns comes increased risk.  If the issuing company does not guarantee 100% of the principal and no index-linked interest due is stated value can be lost.  In addition, a decline in the market index, or if the annuity is surrendered while a surrender charge is in effect can also result in a loss.  Indexed annuities typically have lengthy surrender periods with a surrender charge equal to a percentage of the amount withdrawn or a reduction in the index-linked interest credited to the contract.  In addition, any withdrawals before age 59 ½ may also be subject to a 10% penalty tax.

  • Indexing Method – The relevant index on which increases or decreases in the value of the annuity differs.  This different method from company to company can impact the amount of interest credited to the contract.
  • Participation Rates – The percentage in the amount of gain in the chosen index will determine the equivalent percentage of participation.  For example, if an indexed annuity has a 75% participation rate, the annuity will be credited with 75% of the gain experienced by the index.
  • Spread/Margin/Asset Fee – If an indexed annuity contains a spread/margin/asset fee instead of a participation rate, the percentage of this spread is taken from the overall gain of the index.  For example, if the indexed annuity has a 3% spread and the index gains 10%, the interest credited to the annuity will be 10% – 3% (the spread).

Interest Rate Caps – Sometimes an indexed annuity contains a cap or upper limit on the amount of interest earned by the annuity.  For example, if there is a cap rate of 12%, and the index linked to the annuity gains 15%, only 12% will be credited to the annuity.

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