Variable vs. Fixed Annuity

(What's the difference?)

Variable Annuity Vs. Fixed

Running out of money is a top concern in retirement, according to the Personal Financial Planning Trends Survey by the American Institute of CPAs. Annuities have special features and tax benefits, courtesy of Uncle Sam, because they’re intended to provide a lifetime retirement income.

Annuities come in two flavors, fixed and variable. Here are the differences between them.

Talk to an independent insurance agent and ask them if an annuity is right for you.

How Does a Fixed Annuity Work?

The values of a fixed annuity are guaranteed by the insurance company. The guarantees apply to:

  • The cash value:  Payments made accumulated at the interest rates applied.
  • The surrender value:  The cash value minus any charges for cashing in the policy.
  • The annuity payout factors:  The rate applied to calculate annuity income.
  • Minimum interest rate:  The rate applied to the cash value.

Fixed annuity interest rates offered change regularly.

Some fixed annuities are called indexed. Fixed-indexed annuities offer growth potential without stock market risk. Index accounts credit some of the gains of a market index like the S&P 500 and none of the losses. 

How Does a Variable Annuity Work?

The values of a variable annuity are investments selected by the owner, called subaccount funds. Like mutual funds or other investments, the value of the subaccounts is based on market performance. They aren’t guaranteed.

Money can be transferred between subaccount funds without any tax consequences.

Variable annuities have features called living benefits that offer “downside protection” to investors.

Some variable annuities are called indexed. Variable-indexed annuities offer a level of protection against market losses selected by the investor. 10% and 20% downside protections are common. In exchange, the growth in the account is limited or capped by the insurance company.

Features of Variable and Fixed Annuities

The chart below summarizes the features and benefits of variable and fixed annuities.

Feature Variable Annuity Variable-Indexed Annuity Fixed Annuity Fixed-Indexed Annuity
Tax-deferred growth Subaccount capital gains and dividends Segment growth Interest Interest credits
Tax-free transfers between subaccounts Yes N/A N/A N/A
Guaranteed account values No No Yes Yes
Guaranteed income available Yes Yes Yes Yes
Selection of investments Yes No No No
Selection of index measures N/A Yes N/A Yes
Optional benefits Living benefit riders, enhanced death benefit riders, long-term care No Long-term care Living benefit riders, enhanced death benefit riders, long-term care
Guaranteed rates of return No No Yes Yes
Cost Asset-based fees between .5% and 4% Plus. Surrender charges. Surrender charges Surrender charges, market value adjustment Surrender charges, market value adjustment
Death benefits Standard is greater of account value or purchase payment, enhanced death benefits available for a fee. Standard Is greater of account value or purchase payment, enhanced death benefits available for a fee. Account value Standard is greater of account value or purchase payment
Creditor protection By state By state By state By state

Does a Fixed Annuity Cost Less Than a Variable Annuity?

Variable and fixed annuities both have surrender charges. Variable annuities have ongoing asset-based charges that are a percentage of the account value. Fixed and fixed-indexed annuities often have market value adjustments during the surrender period. 

The insurance company pays a fixed rate of return and absorbs any market risk. If you cash in your contract early, the insurance company loses money if interest rates are rising. The insurance company profits if interest rates are declining. The market value adjustment will be a cost or a bonus depending on interest rates.

Optional riders like long-term care, living benefits, and enhanced death benefits have a cost. The fee is usually a percentage of the cash value. 

Summary of fixed and variable annuity charges

Cost Definition Variable Annuity Variable-Indexed Annuity Fixed Annuity Fixed- Indexed Annuity
Mortality & expense Percentage of account value, charge is for the cost of providing death benefit and payout options, range is .5%-1.2% Yes No No No
Investment manager Charge to professionally manage subaccount funds, range is .25%-2% Yes No No No
Administrative Fees for transactions and policy maintenance Yes Yes Yes Yes
Surrender charges Charges for early withdrawal of funds  Schedules vary from 10 years to 0 years Schedules vary from 10 years to 0 years Usually the same number of years as the interest rate guarantee Schedules vary from 10 years to 0 years
Market value adjustment Charges for early withdrawal No No Yes Yes
Optional riders Charges for optional features Asset-based for GLWB, GMAB, enhanced death benefits, long-term care benefits No Long-term care rates based on age Asset-based GLWB, GMAB, long-term care

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The income from a fixed annuity is determined by the account value and the option that you select. Variable annuities offer income options that go up and down with market performance. 

Variable annuities also have income options that have guaranteed minimums. Some investors use variable income as a tool to keep up with inflation in the future. Others prefer the guarantees of a fixed annuity income. 

Fixed and Variable Annuities: Pros and Cons

Fixed annuities offer guarantees of principal and rates of return. Variable annuities offer the potential for higher growth, along with the risk of loss of principal. The importance of guarantees vs. potential for market growth may be affected by how far away you are from retirement.

Variable annuities have many optional benefits, but they come at a cost. The expenses of a variable annuity and all of the options can be as high as 4% or more. Fixed annuities don't have mortality and expense charges, or optional benefits.

Indexed Annuities: Pros and Cons  

Indexed annuities offer market participation and principal protection. Insurance companies offering indexed annuities offer to protect principal in exchange for a limit on growth. 

Fixed-indexed annuities guarantee principal. The account value is never less than the original purchase payment. It's important to remember that surrender penalties and other charges may apply in the early years of the annuity. 

The growth of a fixed-indexed annuity is limited by the insurance company. The growth potential of a fixed-indexed annuity is generally less than a variable indexed annuity.

Variable-indexed annuities do not guarantee the principal. Instead, the investor chooses a level of downside protection. The insurance company will cover losses up to the level selected by the investor. The growth potential of a variable-indexed annuity is generally higher than a fixed-indexed annuity, but there is still some risk of market losses. 

Annuities and Your Retirement Plan

Annuities are a flexible financial tool. They are well-suited to be a supplemental retirement savings plan. Here are some things to consider:

  • If you are contributing the maximum to your workplace retirement plan or you don't have access to one, an annuity may be a good alternative for you.
  • If you are nearing retirement and need to create guaranteed income, annuities offer a variety of options.
  • Fixed annuities often pay a higher rate than a CD, and the interest is tax-deferred.
  • If you are an active investor, the tax-deferral and tax-free transfer features of variable annuities may be attractive.

Annuities can be an important part of your retirement plan. While they have many features and benefits, they are not for everyone. 

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