FIXED VS. VARIABLE ANNUITIES: WHAT’S THE DIFFERENCE?
WHAT IS AN ANNUITY?
At its core, an annuity is an investment vehicle designed to provide a regular income payment in the future for a specified length of time (20 years, life, etc.). You can think of an annuity as a type of income “insurance.” You can make a one-time premium payment or recurring contributions into the annuity for a set number of years. From this, the annuity company will determine the value of your future monthly payments. Some annuities, called immediate annuities, make monthly payments right away, while deferred annuities start payments at a predetermined future date.
One advantage to annuities is that they are tax-deferred. This means you are not taxed on any income or gains in the annuity until you withdraw funds or start taking income payments, or a death benefit is paid. Annuities can be funded with retirement plan money (“qualified” funds) or “nonqualified” funds (e.g., joint accounts, trusts, etc.). You can also transfer existing annuities into new contracts without triggering a taxable event, although you may be subject to surrender charges.
Annuities can be used for myriad reasons: as an income generator, a life insurance substitute, or a long-term care supplement. They are often a fixture of the conservative block of a portfolio. Underlying the value and structure of the annuity itself, however, is whether it is a fixed or variable annuity.
FIXED ANNUITIES
Fixed annuities, as can be deduced from their name, guarantee a fixed return on the investment and therefore on the future payments. In other words, fixed annuities let you know exactly what to expect in future payments. Fixed annuities guarantee that you will not lose your principal. In exchange for this protection, however, contracts often offer relatively low rates of return.
For example, you might sign a contract that guarantees a fixed 3.5% return on your money. If you fund the contract at the beginning with a single premium payment of $100,000, you’ll have a $3,500 gain by the anniversary of your contract. (All hypothetical numbers are gross and do not reflect fees or other charges you might incur in the policy, such as for riders.)
Fixed indexed annuities give you the option of allocating the cash in your annuity toward a fixed account, where you are guaranteed a certain rate (such as the 3.5%); an indexed account, where your returns match those of the market up to a cap (and if the market is down, you neither gain nor lose anything); or a combination of both. For example, if you have a $100,000 annuity and allocate 50% to a 3.5% fixed account and 50% to an indexed account with a 7% cap, you’ll be guaranteed $1,750 in the fixed account (3.5% x $50,000). If the market is up 9% on your anniversary date, you’ll receive $3,500 in the indexed account (7% x $50,000) for a total gain of $5,250 for the contract year. If the market is down, you will still receive the $1,750 in the fixed account, but nothing in the indexed account.
Fixed annuities often appeal to people who want a little more upside than they could get in a certificate of deposit (CD) or in bonds while still taking very little risk. Because the fixed account is guaranteed, the risk is not directly in the market itself but rather in the solvency of the issuing company, which is why doing your due diligence is important before signing a contract. However, because the fixed rates are guaranteed, they are often conservative and don’t increase if interest rates increase. You’re also exposed to inflation—your fixed income payment will not rise with time and inflation. Some contracts will mitigate this risk by offering an inflation rider at an additional cost. Nonetheless, fixed annuities can be a good choice for those who are risk averse, want to know what to expect for future income, or are looking for a conservative option in their overall portfolio.
VARIABLE ANNUITIES
Variable annuities are a little more complicated than their fixed counterparts. Like fixed annuities, variable contracts guarantee a regular payment as income. As implied by the name, however, that payment is not a set number. Instead, the payments—as well as the underlying value of the annuity on which those payments are based—are tied to the performance of the selected investments, usually mutual funds, within the annuity. As the returns fluctuate with the market, so too will the payments.
Compared to fixed annuities, variable annuities offer an opportunity for higher returns than the going interest rate. The tradeoff is that neither the gains nor the principal is protected against moves in the market, which means that the value of the annuity can decline. Furthermore, while even fixed annuities charge fees, including mortality and expense risk fees, variable annuity fees include fund expenses charged within the mutual funds themselves, and the insurance company will often restrict your mutual fund investment options.
OTHER CONSIDERATIONS
Fixed and variable annuities are tax-deferred, although withdrawing funds before age 59½ may subject you to a 10% tax penalty. Whether or not your annuity is funded with qualified (retirement) or nonqualified money determines taxation on future withdrawals and payments. Also note that most annuities charge surrender fees that can apply if you decide to transfer or withdraw from the contract early, so carefully consider your options and liquidity needs before signing a contract. Many annuities offer a death benefit as an additional feature, so you don’t lose your investment if you die before or during the payment period. Furthermore, Florida, as well as some other states, shelter annuities from creditors and lawsuits, and the Florida Life and Health Insurance Guaranty Association offers protection for some annuities up to certain amounts if the insurance company fails. Nonetheless, always do your due diligence before opening an annuity.
DIFFERENT VEHICLES, DIFFERENT APPLICATIONS
Fixed and variable annuities have their place in the pantheon of investment vehicles, and both have pros and cons. Fixed annuities offer less risk and guaranteed rates of return in exchange for lower rates of return. Variable annuities potentially provide for larger gains but do not protect against the downside, including loss of principal. Understanding your needs and aligning them with policies offered by reputable insurance companies is paramount before making a decision.
Here at Day Hagan Private Wealth, we believe that annuities can, for some clients, be an appropriate investment option. Reach out to us for an analysis of your financial situation, including an evaluation of any of your current annuities. If an annuity is right for you, we offer a range of products, including fee-based annuities, that may fit your needs. It’s time to organize your portfolio. It’s time to talk to Day Hagan.
Natalie Brown, CFP®
Director of Client Services
Day Hagan Private Wealth
—Written 02.04.2021
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Investment advisory services offered through Donald L. Hagan, LLC, a SEC registered investment advisory firm. Accounts held at Raymond James and Associates, Inc. (member FINRA, SIPC) and Charles Schwab & Co., Inc. (member FINRA, SIPC). Day Hagan Asset Management and Day Hagan Private Wealth are both dbas of Donald L. Hagan, LLC.