Fixed vs variable vs immediate vs deferred. What does it all mean?
One of the confusing aspects of annuities is the various types available. Each type has its own set of rules and is often used in different situations. Here is a tutorial on the four most common types of annuity and how they often overlap.
Let’s begin with a simple concept about all annuities that can help you distinguish these terms.
All annuities can be divided into two phases. The first is the accumulation phase. This is the period during which your annuity’s account value is accumulating interest.
The second phase is the income, or distribution, phase. During this timeframe, the annuity is paying out income.
Fixed and variable
The terms fixed and variable distinguish how interest is credited to the annuity contract. These terms apply to the accumulation phase of your annuity contract, when its account value is growing.
A fixed annuity credits a set rate of interest for a given period. In most cases, the interest will be compounded, meaning you will receive a percentage of the current account value. For example, if your $100,000 annuity pays a 3 percent compounded annual interest rate, the annuity will have an account value of $103,000 the following year. The year after, the account value will grow to $106,090 (103,000 x .03 + 103,000).
The interest credited on a variable annuity will vary year to year. It will be based on the performance of the investments you choose within the annuity contract. With a variable annuity, you direct the insurance company to invest your premium in one or more subaccounts, which are mutual-fund like investments. Like mutual funds, these subaccounts offer different investment options in stocks, bonds, money market funds, and other securities. The number and variety of subaccount options will vary by company. The money in those subaccounts will increase or decrease over time, depending on their performance.
Immediate and deferred
The terms immediate and deferred describe when the annuity begins paying income. Therefore, these terms apply to the distribution phase of your annuity contract, when it pays income from the account value.
An immediate annuity, as its name implies, pays income as soon as you purchase the product. The annuity’s account value is essentially the amount of premium you pay to the insurance company. The income will be based on that amount, plus your age, gender, and how long you want to receive payouts.
A deferred annuity is a product in which you buy it today and wait several years before receiving income. You can defer as little as a few years or as many as 20 or more. While your deferring your income, interest is being credited to your account value. So in most cases, the account value will be larger when you begin taking income than when you purchased the annuity.
With both immediate and deferred annuities, the income you receive will be expressed as a percentage of your account value, not as the payout percentage or cashflow rate.
Now that you understand each of these terms individually, you can better comprehend the various types of annuity.
Fixed immediate annuities are the most predictable type of annuity you can purchase. Income begins once the contract is finalized, and that income amount is fixed; in general, it doesn’t change for as long as you collect income.
For example, if you deposit $100,000 in a fixed immediate annuity and the insurance company agrees to an annual payout percentage of 6 percent for the rest of your life, you will receive $6,000 a year for the rest of your life. The older you are when you buy the annuity, the higher your income payments.
A fixed deferred annuity allows you to defer your income stream for several years. During the accumulation phase, the annuity’s account value grows tax-deferred based on the fixed rate of interest set by the insurer.
When it comes time to take income, you can choose a lump sum of your account value or a stream of periodic payments. With the stream of payments, you can choose how long you want to receive income, be it for a set number of years or for life.
A variable immediate annuity begins paying income immediately. But these types of annuities allow you to invest your premium in subaccounts that can increase in value. If those investments grow, the amount of your income payments will grow as well. However, the opposite holds true if those investments decrease in value.
With a variable deferred annuity, you are deferring your income stream for several years. During the accumulation phase, the subaccounts you invest in grow tax-deferred, depending on the performance of the underlying investments.
When it comes time to take income, you can choose a lump sum of your subaccount value or a stream of periodic payments. With the stream of payments, you can choose how long you want to receive income, be it for a set number of years or for your lifetime. Also, if you opt for a stream of payments, the money remaining in your subaccounts will continue to grow or lose value, depending on the performance of those funds.
If the terms fixed or variable or used with an immediate annuity, they will be describing whether your income is set at a fixed rate or can vary. If those terms are used with a deferred annuity, they are describing whether your account value will collect interest at a fixed interest rate or a variable interest rate.