Annuities: What Everyone Should Know Before They Invest

AM5279 thumbing a thick stack of American paper money $100 dollar bills.  cash; money; rich; wealthy; success; wad; lottery; gai

Annuities are among the most controversial products in the investment world, with proponents and critics fiercely disagreeing about their benefits and limitations. Yet annuities are just another tool that investors have for financial planning. Let's look at five of the most common types of annuities and the features and potential pitfalls they offer to investors.

1. Fixed Annuities

As their name suggests, fixed annuities offer investors a fixed interest rate on their investment for a certain period, making them closely resemble bank certificates of deposit. But as an insurance product, fixed annuities are entitled to tax-deferred treatment for their earnings. In addition, fixed annuities will often offer higher interest rates than bank products, and given the current low-rate environment, that makes annuities an attractive alternative for many conservative investors.

But fixed annuities aren't the same as bank CDs. Unlike CDs, fixed annuities aren't guaranteed by the FDIC, although the individual insurance company that issues the annuity stands behind the annuity with its own corporate guarantee. Moreover, fixed annuities often include limitations on the amount of money you can withdraw over specified time frames, imposing additional fees under certain circumstances.

2. Variable Annuities

Variable annuities give investors exposure to different types of assets, which makes them look a lot like mutual funds. Like fixed annuities, variable annuities offer tax-deferred growth until you start making withdrawals. In addition, most variable annuities offer the option of getting guaranteed benefits, ranging from a minimum benefit at your death to minimum provisions for income and withdrawals throughout your lifetime.

The features that variable annuities offer come at a price, though, with costs that are sometimes much higher than a mutual fund that invests in similar stocks or other investments. Moreover, the same limits on withdrawals often apply to variable annuities, and those under age 59½ will have to pay penalties on earnings if they need their money back before then.

3. Immediate Annuities

Immediate annuities are designed to resemble what most people get from pensions and Social Security. As soon as you buy the annuity, the insurance company starts making monthly payments to you based on your life expectancy and the prevailing interest rates. Unless you choose special provisions to the contrary, after your death, the insurance company will stop making payments, keeping any excess as profit.

Immediate annuities can be quite valuable to reduce longevity risk -- meaning the risk that you'll run out of money before you die. The longer you live, the more you'll profit from having chosen an immediate annuity. Those who die before they reach full life expectancy end up subsidizing the longer payout periods of those who don't. Unfortunately, in the current low-rate environment, the monthly payments you'll get will be smaller for any given up-front payment than in past years.

4. Deferred Income Annuities

Deferred income annuities are much like immediate annuities in that they provide dependable income throughout a lifetime. The difference, though, is that deferred income annuities don't start paying benefits out immediately. Rather, they're designed to wait until you're a certain age before triggering and starting to make payments.

The trade-off with deferred income annuities is that by waiting, your eventual monthly payments from the annuity will be larger. In exchange, though, the risk of dying before you reach the age at which the annuity will start making payments is greater, and so it's more likely that you could lose everything you invest. As with immediate annuities, alternatives are available to leave something for your heirs, but they come at the cost of smaller benefits for you.

5. Equity Indexed Annuities

Equity indexed annuities sound like a simple product, but they're deceptively complex. Their returns depend on movements of an underlying stock index like the Dow Jones industrials (^DJI) or the S&P 500 (^GSPC), but they don't generally track the stock market directly. Instead, most equity indexed annuities offer minimum returns even if the stock market crashes, and in exchange, they offer only a portion of the return of the index and sometimes cap upside gains if the market soars. Most important, most of these annuities don't include the dividends that investors in index funds would receive.

In addition to fees and potential charges for early withdrawal, equity indexed annuities can be very difficult to understand,the watchdog agency Financial Industry Regulatory Authority warned in an Investor Alert in 2010.

Be Smart About Annuities

Annuities can be difficult to understand, with various products offering much different benefits and costs. By knowing the various types of annuities, you'll find it easier to tell if one particular annuity is the best one for you.

You can follow Motley Fool contributorDan Caplingeron Twitter@DanCaplingeror onGoogle Plus. To read about our favorite high-yielding dividend stocks for any investor, check outour free report.

This content is not available due to your privacy preferences.
Update your settings here to see it.