Fixed Annuities vs. Variable Annuities – Pros And Cons
When it comes to securing a steady stream of income for your retirement years, annuities can be powerful financial tools. However, not all annuities are created equal. The two main types – fixed annuities and variable annuities – have distinct characteristics that cater to different investment goals, risk tolerances, and retirement income needs. In this comprehensive guide, we’ll explore the key differences between these annuity options to help you make an informed decision that aligns with your unique financial situation.
What is a Fixed Annuity?
A fixed annuity is a contract between you and an insurance company. You make a lump-sum payment or a series of payments, and in return, the insurer guarantees a fixed rate of return on your investment. This fixed interest rate is determined at the time of purchase and remains unchanged throughout the duration of the contract, providing you with a predictable and stable income stream during retirement.
According to LIMRA, sales of fixed annuities reached $95.6 billion in 2023, a 20% increased from 2022.
Here are the pros and cons of a fixed annuity:
Advantages of fixed annuities
Disadvantages of fixed annuities
What is a Variable Annuity?
In contrast to fixed annuities, variable annuities are tied to the performance of underlying investment sub-accounts, similar to mutual funds. When you purchase a variable annuity, you can allocate your contributions across various sub-accounts, each with its own investment objective and risk profile, such as equity funds, bond funds, or money market funds.
According to LIMRA, sales of variable annuities reached $51.4 billion in 2023, a 17% drop from 2022.
Here are the pros and cons of a variable annuity:
Advantages of variable annuities
Disadvantages of variable annuities
Main Differences Between Fixed and Variable Annuities
Here is a 1:1 comparison of fixed annuities vs. variable annuities:
Risk Profile:
Fixed annuities are considered low-risk investments, as they offer a guaranteed interest rate and principal protection, shielding your investment from market fluctuations. Variable annuities, on the other hand, are higher-risk investments, as their performance is directly tied to the underlying investments in the sub-accounts, exposing you to market volatility and the potential for losses.
Growth Potential:
While fixed annuities provide a stable and predictable income stream, they typically offer lower growth potential compared to variable annuities. Variable annuities, with their exposure to the stock market and other investment options, offer the opportunity for higher returns over the long term, allowing your investments to potentially grow at a faster rate.
Investment Options:
Fixed annuities offer a single investment option with a guaranteed interest rate, providing simplicity but limited diversification. In contrast, variable annuities provide a wide range of investment options through sub-accounts, allowing you to diversify your portfolio and customize your investment strategy based on your risk tolerance and investment goals.
Income Stream:
With a fixed annuity, the income stream is predetermined and fixed, providing a reliable and predictable source of income during retirement. This can be particularly beneficial for budgeting and financial planning. With a variable annuity, however, the income payments fluctuate based on the performance of the underlying investments, introducing volatility into your retirement income stream.
Costs and Fees:
Fixed annuities generally have lower fees compared to variable annuities, which often have additional charges for managing the sub-accounts, administrative costs, and optional riders or features. It’s essential to carefully evaluate the fees associated with each annuity option, as they can significantly impact your overall returns and income stream.
What Is The Right Annuity for Me?
When deciding between a fixed or variable annuity, carefully evaluate your individual circumstances, investment goals, risk tolerance, age, time horizon, retirement income needs, existing assets, and tax situation.
If you prioritize safety, stability, and preservation of principal, a fixed annuity may be the more suitable choice, especially if you are risk-averse or nearing retirement. The guaranteed interest rate and principal protection offered by fixed annuities can provide peace of mind and a reliable source of income to cover essential expenses during your golden years.
On the other hand, if you are comfortable with market volatility and are willing to take on higher risks for the potential of higher returns, a variable annuity might be a better fit, especially if you have a longer investment horizon. Variable annuities allow you to participate in the potential growth of the stock market and other investment options, which can be beneficial if you have additional financial resources or are seeking to supplement your retirement income with potential growth opportunities.
It’s also important to consider your existing assets and portfolio diversification. If you already have a well-diversified portfolio with exposure to various asset classes, a fixed annuity could provide a stable component to balance out market fluctuations and ensure a portion of your retirement income is guaranteed. Conversely, if your portfolio is more conservative or heavily weighted towards fixed-income investments, a variable annuity could introduce some growth potential and diversification.
Additional Features and Options Of Annuities
Both fixed and variable annuities offer various additional features and options that can be tailored to your specific needs and preferences. Understanding these options can help you make a more informed decision when selecting the right annuity for your retirement income strategy.
➡ Immediate Annuity vs. Deferred Annuities
Regardless of whether you choose a fixed annuity contracts or a variable annuity, you’ll have the option to structure it as an immediate or deferred annuity. The primary difference lies in when you begin receiving income payments.
Immediate Annuities: As the name suggests, immediate annuities start paying out income shortly after you make your initial lump-sum payment to the insurance company. This option is suitable for individuals who are already retired or nearing retirement and require a steady income stream to cover living expenses.
Deferred Annuities: With a deferred annuity, your investment has the opportunity to grow over an accumulation period before you start receiving income payments. This option is ideal for those who are still in their working years and want to let their annuity grow tax-deferred until they reach retirement age. Deferred annuities allow you to take advantage of compounding returns, potentially resulting in a larger income stream when you begin taking distributions.
➡ Guaranteed Income Riders
Variable annuities often offer an optional guaranteed income rider, which can provide an additional layer of protection for your retirement income. These riders, which come at an additional cost, guarantee a minimum level of income payments, regardless of how the underlying investments in your variable annuity perform.
For example, suppose you purchase a guaranteed minimum withdrawal benefit (GMWB) rider. In that case, you’ll be assured of receiving a specified income level, even if the value of your variable annuity account declines due to market downturns. This feature can provide peace of mind and income protection, especially during market volatility.
➡ Death Benefits
Both fixed and variable annuities typically include death benefit provisions, which can help protect your legacy and provide financial security for your loved ones. If you pass away before receiving all the income payments from your annuity, your beneficiaries will receive a specified amount, typically equal to the remaining account value or a predetermined minimum amount.
Some annuities offer enhanced death benefit options, such as a guaranteed minimum death benefit (GMDB), which ensures that your beneficiaries receive at least the amount you initially invested, even if the account value has declined due to market performance or withdrawals.
➡ Annuitization Options
When you are ready to start receiving income payments from your annuity contract, you can annuitize, which means converting your account value into a stream of regular payments. Both fixed and variable annuities offer different annuitization options, allowing you to choose the payout structure that best suits your needs.
Life Income Option: With this option, you’ll receive income payments for the rest of your life, regardless of how long you live. This option can provide peace of mind, as you won’t have to worry about outliving your retirement savings.
Joint and Survivor Income Option: This option suits married couples or partners. It provides income payments for as long as either you or your spouse/partner is alive, ensuring that the surviving partner continues to receive income after the other passes away.
Period Certain Option: With this option, you’ll receive annuity payments for a specified period, such as 10, 15, or 20 years. This option can be useful if you have a specific income need for a defined period, such as covering expenses until you become eligible for Social Security or another retirement income source.
By understanding these additional features and options, you can customize your fixed or variable annuity to better align with your specific retirement income needs, risk tolerance, and overall financial goals.
Seek Professional Advice For A More Confident Decision
Choosing between a fixed or variable annuity is a complex decision that involves numerous factors and considerations. It’s crucial to seek professional advice from a qualified financial advisor who can help you evaluate the annuity contracts, understand the fine print, and integrate the annuity into your comprehensive retirement plan.
A financial advisor can provide valuable insights into the pros and cons of each annuity option, considering your unique financial situation, risk tolerance, and long-term retirement goals. They can also help you navigate the tax implications of each annuity and ensure that your retirement income strategy aligns with your overall tax strategy.
Ultimately, both fixed and variable annuities can be valuable in securing your retirement income. By understanding the main differences, carefully evaluating your personal circumstances, and seeking professional guidance, you can make an informed decision that maximizes your retirement income and provides financial security for your golden years.
