Fixed vs. Variable Rate Annuities

The difference between fixed and variable rate annuities is how the insurance company invests your money. The manner in which it is invested impacts the rate in which it is paid out as income.

Fixed annuities provide a series of regular payments of a specified dollar amount for the specified term. The advantage is that you can count on getting the same amount of money each month for the entire annuity term. Conversely, variable annuities still provide payments at planned intervals, but the amount of those payments fluctuates based on how the underlying investments performed during that period. The main advantage is the opportunity for better investment performance with a variable annuity than with a fixed rate annuity.

Fixed Annuities

Fixed annuities offer guaranteed investment performance. You will be able to calculate your precise investment performance for the period with which the insurance company provides you a guarantee. Those guarantees extend typically from one to fifteen years, depending upon the insurer and the specific product. Fixed annuities are secure; you can plan on exactly how much income you will receive. Fixed annuities are held in the issuing insurance company’s general investment account and typically invested in government securities and high-grade corporate bond funds.

Because your fixed annuity assets are part of the insurance company’s general account, they are subject to the claims-paying ability of that company. What this means is that the promise to pay you for your life is only as reliable as the financial strength and stability of the insurer. If you are considering an annuity, it is advisable to research the issuer’s rating with independent rating agencies. Insurers with high ratings with the rating agencies are considered more financial security than those that do not.

Most fixed immediate annuities provide a level payment for the rest of your life. The fixed level may not keep pace with inflation. Therefore, some companies offer a fixed level Cost of Living rider that you can be added-on to your annuity contract. This rider adjusts your income annually to keep pace with inflation. The trade-off you will make is to have lower payments in the early years, to counter-balance the higher amounts paid in the later years.

Variable Annuities

Variable annuities involve more risk than fixed annuities, but offer the potential for higher return.

Unlike fixed annuities that provide a guaranteed return, the payments from a variable annuity will fluctuate.

First introduced in the late 1950s by the Teachers Insurance and Annuities Association â€" College Retirement Equity Fund (TIAA-CREF), variable annuities were designed to appeal to investors who were unimpressed with the conservative investment performance that most fixed annuities offered. They were geared to more aggressive investors who had higher risk tolerances but who also wanted to take advantage of tax-deferral.

With variable annuities, your money is invested by the insurance company in portfolios called sub-accounts. Sub-accounts are similar to mutual funds. The amount of income you receive fluctuates with each payment depending on the performance of the sub-accounts you choose.

The insurance company provides you with a wide range of investment options ranging from the full spectrum of asset classes. Many advisors would advise you to diversify your annuity portfolio much like you do your overall investment portfolio. Therefore, you would invest a portion of your annuity holding in conservative accounts, such as a guaranteed fixed accounts and government bond funds, while also attributing portions to more aggressive investments.

If you are interested in pursuing a variable annuity, one of the key decision points for you will be the breadth of investment choices offered by your insurer. More robust products include as forty or more investment choices with ten or more managers.

You can generally switch between investment options at no cost and without tax consequences. This means that if funds are moved from one option to another within a variable annuity, taxes are not due on any money that has been earned. So, if the market in a particular sector is down, you can transfer to another fund that offers more growth potential. Your insurer may require you to keep a minimum amount in a money market fund to cover annuity expenses, and may restrict the number of transfers made within a certain period.

Variable annuities have been subject to extensive regulation since their origination in the 1950’s. Because they were given preferred tax treatment (tax-deferral), and designed to encourage Americans to save for retirement, the IRS has enacted penalties for early withdrawal. To deter early withdrawal, you will have to pay a 10% tax on the amounts withdrawn before age 59½.

Variable annuities are complex investments. When considering a variable annuity you should be provided with, and review carefully, a prospectus.