Immediate vs. Deferred Annuities
The first basic distinction among annuities contracts is between immediate vs. deferred. As we have seen in various blog posts, all annuities are designed to be irrevocably converted into income at some point, by definition.
We might even say that deferred annuities—those that appear designed to grow like bank or investment accounts and offer some access to our principal—are simply waiting to grow up into immediate annuities, at which point our claim on principal goes poof, and we have only a stream of periodic checks where once was a mighty pool of liquidity. Once again, by contract and by design, a deferred annuity is an immediate annuity waiting to happen.
In a moment, we are going to pretend that there really is a distinction, but you MUST forever bear in mind that annuities are designed to ultimately convert liquid principal into income according to some contractual scheme. This is a fundamental characteristic of what annuities are. We’ll get into a bit more detail later, and for now will focus on the very basics. Ok, here we go.
Deferred annuities
Deferred annuities—remember, these are by contract only immediate annuities in waiting, designed ultimately to annuitize the accumulated value into a payout stream on which the insurance company still plans to make money—are packaged to really look like investment products.
It is therefore the payout—not taxes, as so many improperly infer—that is deferred in deferred annuities. It is this payout function, latent and lurking in deferred annuities, which is what makes an annuity an annuity. Never forget this.
Deferred annuities surrender charges
With deferred annuities you put in so much (up front, on a regular monthly or other basis, or both) and hope to watch your money grow. With all of these, you need to beware of surrender charges, which are fees that you will pay if you decide to get out of your contract and move the money, even into another annuity contract.
Some contracts will assess a flat percentage, which will usually decline a bit each year (or after each of several years) by a percentage point or two, until the surrender period has passed. These surrender charge percentages have ranged from the merely expensive (like 3 or 4 or 8 percent) to the truly outrageous, like 30% of your invested principal, or more. It doesn’t look like much, but 6% of $200,000 is $12,000, if you decide you want your money, and 15% of the same sum is $30,000. Surrender periods can range from a few years to over a decade or more.
It can be easy to rationalize away surrender charges because you plan to keep the annuity for a long enough term to get past them, but remember how tightly they can limit your options. If interest rates go up again, but your contract does not keep up (because the insurance company is stuck with the low-yielding investments they put your money in or knows you are unlikely to leave and pay a big surrender charge), you may find the liquid restrictions really cut into your returns.
So remember, deferred really means that the annuitization component, gateway into the land of lost liquidity, is by contract deferred to some future date.
Fixed Annuities
The first flavor is commonly referred to as fixed annuities. These are the simplest to understand, and analogous to CDs and other deposit accounts at banks. It is important to remember that the guarantees on these insurance products are far weaker than FDIC-type guarantees on bank accounts. They pay specific annual interest, usually set in advance each year with guaranteed minimum interest levels. They can get wickedly complicated, what with bonus interest and other smoke-and-mirrors inducements, but at their core are very simple, at least for the insurance company issuing the contract.
There’s lots of varieties of fixed annuities including the wickedly complex equity index type, which we explore in detail in the other posts in this blog section.