Which Is Better for Retirement?
Annuities have become an increasingly popular option for retirement planning and generating a steady stream of income during retirement years. The two main types of annuities available are fixed and variable annuities, each with its own pros and cons. Understanding the key differences between fixed and variable annuities determines which type may be better suited for an individual’s financial goals and risk tolerance!
What is an Annuity?
An annuity is a contract between an individual and an insurance company that provides a guaranteed income, either immediately or in the future. The individual makes either a lump-sum payment or a series of payments to the insurance company. In return, the insurer agrees to make regular income payments beginning either right away or at some future date, like retirement.
Annuities are most commonly used as part of a retirement plan to supplement other retirement income sources like Social Security and personal savings. They provide retirees with a predictable stream of income that can help cover expenses in retirement. Annuities allow savings to grow on a tax-deferred basis, meaning no taxes are owed until funds are withdrawn.
Annuities have different types, including Fixed, Variable, Indexed, Immediate, and Deferred annuities. Today, let’s dig into the details of two key players: fixed and variable annuities.
Overview of Fixed Annuities
A fixed annuity offers a guaranteed, predictable rate of return that is set by the insurance company. The insurer invests premium payments in conservative assets like bonds. Interest earnings on fixed annuities accumulate tax-deferred.
With a fixed annuity contract, the insurance company promises to pay a minimum guaranteed interest rate. This provides investors with a reliable, steady stream of income they can count on. Fixed annuities are considered low-risk because even if the insurer earns higher returns on underlying investments, your rate of return remains fixed, ensuring you won’t lose money.
Pros Of Fixed Annuities
- Principal protection – Your initial investment and earnings are protected against market fluctuations.
- Guaranteed interest rates – Fixed annuities guarantee a minimum rate of return.
- Simple – Easy to understand with lower maintenance.
- Stable income – Provides a reliable income stream.
- Immediate or deferred payments – Can receive payments right away or defer them until later.
Cons Of Fixed Annuities
- Lower returns – Tend to offer lower returns than variable annuities over the long run.
- Inflation risk – Guaranteed fixed payments may lose value over time due to inflation.
- Limited liquidity – Steep penalties usually apply for early withdrawals.
- Higher fees – They include charges such as investment management fees, annuity contract fees, and riders that guarantee income.
Overall, fixed annuities appeal to more conservative investors who prioritize having a predictable source of income over potentially higher investment returns.
Overview of Variable Annuities
Variable annuities provide income payments that fluctuate based on the performance of underlying investment portfolios. Unlike fixed annuities that pay a fixed return, variable annuity payments rise and fall with the value of the investments they hold.
Variable annuities allow you to select from a range of available mutual funds or investment subaccounts to build your portfolio. These subaccounts usually invest in stocks, bonds, money markets, or some combination of the three. You control how your savings are invested, allowing you to be more aggressive in pursuing growth.
As investments gain or lose value, so does the variable annuity’s account value. This means payments can vary significantly over time. However, by investing more aggressively, variable annuities offer greater potential for higher returns than their fixed counterparts.
Pros Of Variable Annuities
- Investment flexibility – Ability to allocate retirement savings across diverse investments.
- Potential for higher returns – Your income payments fluctuate based on markets.
- Immediate or deferred payments – Can start receiving income right away or in the future.
- Death benefit – Beneficiaries receive any remaining value of the account if you pass away.
Cons of variable Cons Of Variable Annuities
- No guarantees – You could lose principal since nothing is guaranteed.
- Higher risk – Vulnerable to volatility and potential losses in market downturns.
- Complexity – More complicated with various fees, charges, and moving parts.
- Liquidity issues – Usually face surrender charges if withdrawing money early.
Variable annuities allow for more growth potential than fixed annuities but carry greater risk. They are better suited for investors with higher risk tolerance and ample time to recover from periodic downturns.
Comparing Main Features of Fixed vs. Variable Annuities
|Fixed, guaranteed return rate
|Fluctuates based on the performance of investments
|Low, predictable returns
|Higher risk tied to the volatility of markets
|No direct sales fees but high contract fees
|Various fees including management fees for subaccounts
|Lower, may face surrender penalties
|Higher, but surrender fees may apply
|Offer Tax-deferred growth
While fixed and variable annuities share some common traits, their distinction lies in how they generate income. Fixed annuities offer low-risk stability, while variable annuities pursue higher returns through increased risk and investment flexibility.
Factors to Consider When Choosing Between Fixed vs. Variable Annuities
Determining whether a fixed or variable annuity aligns better with your financial objectives depends on a few key factors:
Your risk tolerance – This helps establish appropriate risk-return tradeoffs. Conservative investors may prefer fixed annuities, while more aggressive investors seek higher (but variable) gains from variable annuities.
Time horizon – Variable annuities tend to outperform, given sufficient time to overcome market swings. But fixed annuities offer guarantees those close to or in retirement may favor.
Income needs – Fixed annuities provide stable, predictable income payments. However, variable payouts could potentially exceed fixed payments over time.
Inflation – Fixed annuities lose purchasing power over time. Variable annuities may provide greater protection against inflation.
Fees – Variable annuities tend to have higher fees that cut into gains. Fixed annuity contracts have higher contract fees but lower ongoing expenses.
Liquidity – Those needing access to funds sooner may want to avoid steep surrender charges. However, fixed annuities have greater penalties than variable ones.
Hybrid Option: Fixed Indexed Annuities
For investors seeking a middle ground, fixed-indexed annuities combine features of both fixed and variable annuities. Like a fixed annuity, they provide principal protection and guaranteed minimum returns. However, they also offer the potential for higher growth by linking interest earnings to the performance of a market index like the S&P 500.
Returns are “capped” at a maximum amount, limiting upside potential but also protecting against losses when the index decreases. Fixed-indexed annuities offer a balanced alternative for those who want upside potential above a fixed annuity but with more guarantees than a variable annuity.
Conclusion: Weigh Your Needs and Choose Wisely
In summary, fixed and variable annuities each have advantages and disadvantages. There is no definitive “better” option; the right type depends on your individual financial situation.
Those focused on safety opt for fixed annuities. Investors wanting higher returns may prefer variable annuities if aligned with their risk tolerance and time horizon. Hybrid fixed-indexed annuities offer a middle ground. Carefully weigh your income needs, risk comfort, and goals to decide which annuity type best supports a secure retirement plan.
Frequently Asked Questions
What are the main differences between variable and fixed annuities?
The key differences are:
- Fixed annuities provide guaranteed, predictable returns, while variable annuities offer investment flexibility where returns rise and fall with markets.
- Fixed annuities have lower risk with principal protection, while variable annuities carry higher risk but greater return potential.
- Fixed annuities offer a simple, stable lifetime income with lower fees, while variable annuities are more complex with various subaccount and rider fees.
Why would someone choose a variable annuity over a fixed annuity?
Reasons someone may prefer a variable annuity include:
- They have a higher risk tolerance and are comfortable with market volatility.
- They want to invest more aggressively in growth assets like stocks.
- Their time horizon is long enough to potentially achieve higher average returns over time.
- They want to hedge against inflation, eating away fixed payments.
- They value the ability to transfer between investment options.
What are the disadvantages or risks of only using a fixed annuity in retirement?
Potential downsides of relying solely on fixed annuities include:
- Losing purchasing power over time if the fixed payments fail to keep pace with inflation.
- Missing out on potentially higher investment returns compared to variable products.
- Having limited flexibility if financial needs change during retirement.
- Facing steep surrender fee penalties if forced to withdraw funds early.
- Being overly conservative and not earning enough returns to maintain living standards.
For these reasons, fixed annuities may work better as part of a broader retirement portfolio than the sole income source.
Bara is a seasoned expert in the structured settlement and annuity field, with a successful career in structured settlement factoring. Her experience spans prominent companies such as J.G. Wentworth, Peachtree Settlement Funding, and Liberty Settlement Funding, where she managed substantial marketing campaigns. Constantly updating her knowledge, Bara is committed to providing exceptional experiences and maintaining her position as a trusted professional in the industry.