An annuity, a type of insurance product used as a retirement vehicle, can be an effective way to earn a steady income in retirement. When you purchase an annuity, the insurance company uses your contribution money to fund an investment portfolio, which allows the annuity account to grow tax-deferred. You can then convert the annuity into cash disbursements at the end of the contract term, thereby supplementing other income streams, like Social Security, and reducing your risk of running out of money after leaving the workforce.
If you’ve been in the market for an annuity, you know there are multiple types to choose from, with fixed annuities and variable annuities being among the best known. So that you can differentiate between the two types and more easily determine which is right for you, we have created this guide that highlights the key features of each one.
What Is a Fixed Annuity?
A fixed annuity is possibly the most straightforward of annuity types. Like all annuities, it gives you the option to convert it into regular cash disbursements at the end of the contract term, but what distinguishes it from others is that it guarantees a fixed, or set, rate of return. That is, the rate of interest you earn is determined when you purchase the contract, and it does not change.
For example, if you purchase a fixed annuity with an annual percentage rate of 6%, you will realize a 6% return on your annuity every year, without exception. Neither the prevailing interest rates in the larger economy nor the ups and downs of the stock market affect how much the annuity pays out in the end.
What Is a Variable Annuity?
You can think of a variable annuity as the inverse of a fixed annuity. Rather than a fixed rate of return, it offers fluctuating rates that depend on market performance. When you purchase a variable annuity, you choose the assets the insurance company will invest in. If those assets perform well, your rate of return is higher. If they perform poorly, however, your rate is lower. The market-linked nature of a variable annuity means its growth is unpredictable, but you do stand to realize higher-than-usual returns during strong market years.
Fixed Annuities vs. Variable Annuities
While both fixed and variable annuities can be valuable additions to your retirement portfolio, there are some key differences between them, particularly in terms of the benefits and the risks associated with each one.
Aside from tax-deferred growth and a guaranteed income stream in retirement, which all annuities offer, fixed annuities provide a couple of advantages. Primarily, because the rate of return is fixed, they are more predictable than other annuity types. You know how much you will receive after annuitization, so you can more accurately plan your retirement spending before you leave the workforce. Moreover, given the relatively straightforward nature of fixed annuities, consumers often find them easier to understand than other annuity types.
Variable annuities do not guarantee the same predictability and downside protection, but they offer a different set of benefits. One is the potential for a greater upside. In exchange for higher portfolio risk, variable annuities allow you to enjoy accelerated growth on your contributions when your holdings perform well. Should your annuity grow during a particularly robust period for the market, you stand to see some impressive returns upon annuitization.
Another advantage is the lack of contribution limits, which, compounded with the upside potential described above, makes variable annuities a possible alternative to individual retirement arrangements (IRAs). Indeed, a wealthy investor can use a variable annuity to realize more tax-advantaged growth in addition to a traditional or Roth IRA.
In terms of risk, fixed annuities are probably the safer option. With a fixed interest rate, your principal remains protected, and you can be certain that you will realize a certain amount of return over the life of your contract. In contrast, a variable annuity presents a higher level of risk because the returns it may offer depend on how well the market performs. With that in mind, fixed annuities may be the better choice for the more conservative investor, whereas variable annuities are better suited to experienced investors with less risk aversion.
Whether you are looking to secure a guaranteed income stream or maximize your contributions’ upside potential, an annuity can be an excellent addition to your retirement portfolio. The one you choose should align with your financial goals and current capabilities. To ensure that you make the best-informed decision possible, speak with a financial adviser about your options today.