Fixed Annuities vs. Other Annuities: A Comparison

All annuities are insurance contracts. Funded with the annuitant’s contributions and capable of being converted into regular cash payments after the end of their term, they offer a measure of security by providing you with a steady stream of income in retirement. Aside from those common characteristics, though, there are major differences to consider, as annuities encompass a wide range of products that each offer a different set of benefits. 

Making an informed decision about your retirement requires understanding the differences between your options and selecting the one that would best satisfy your financial goals. With that in mind, let’s examine how fixed annuities work and how they compare with other types of annuities.

How Do Fixed Annuities Work?

The primary distinguishing characteristic of a fixed annuity is that it offers a fixed rate of return. When you purchase one, the insurance company determines the interest rate by which the account will grow for every year of its term. Normally, during what is known as the accumulation phase, you fund the annuity with either a lump-sum contribution or a series of smaller contributions. The insurance company uses your contributions to make investments that allow the account to grow tax-deferred, but how well those investments perform has no bearing on the interest you gain. 

At the end of the term, you can decide to annuitize the contract, which means converting it into cash disbursements — the payout phase. The insurance company determines the amount of each payment based on the sum of money in your annuity account calculated against factors such as your age and the total length of the payout phase, which may last for either a specified number of years or the rest of your life. If you have a qualified annuity (funded with pretax dollars), the disbursements are subject to tax.

Advantages of Fixed Annuities

Aside from tax-deferred growth and the prospect of a lifetime income stream, which aren’t exclusive characteristics, fixed annuities offer several advantages:

• Guaranteed rate: The interest rate determined at the beginning of the contract will not waver. If you are promised 8% interest every year, you will earn 8% interest every year.
• Principal protection: Because the interest rate is guaranteed, it cannot sink into the negative, so you cannot lose out on your contributions.
• Predictability: Knowing how much you will contribute and exactly how much interest you will earn throughout the life of the contract allows you to calculate how much you can expect to receive in disbursements after annuitization. That predictability can be helpful in terms of retirement planning.

Fixed Annuities vs. Other Types of Annuities

As you shop for annuities, you are probably going to encounter an array of different annuity types. Below are the four main categories of non-fixed annuities and how they compare:

Variable Annuities

With a variable annuity, the rate of return fluctuates based on market performance. When you purchase one, you select the investments toward which the insurance company will put your money. In the contract years that the funds perform well, your account realizes higher returns commensurate with the level of market performance. In the years they perform poorly, though, your rates of return are lower.

The lack of a fixed rate of return is the chief distinguishing characteristic of a variable annuity compared to a fixed annuity. The element of risk removes the principal protection and predictability of the latter, but it also offers the potential for a higher upside than a fixed annuity can normally offer.

Indexed Annuities

If annuities were represented on a scale, indexed annuities would be positioned someplace between fixed annuities and variable annuities. They, too, offer fluctuating rates of return, but rather than a portfolio of investments, the interest rate for a given contract year depends on the performance of an underlying market index, such as the S&P 500. If the index performs well, your account gets credited at a higher rate. 

Some of the other distinguishing features of indexed annuities are:

• Principal protection: The interest rate for an indexed annuity cannot be below 0%, so you won’t lose out on your principal contribution. There may even be a guaranteed minimum return rate, by which the insurer guarantees that you never earn below a certain minimum threshold.
• Participation rate: The participation rate is a percentage of index gain for your indexed annuity. If the participation rate is 70% and the underlying index gains 10%, your account earns only 70% of the 10% gain — 7% overall for the contract year.
• Spread: The spread refers to a percentage subtracted from the index gain. For example, a 2% spread on a 10% index gain would amount to an 8% overall gain for your account.
• Cap: The cap is the maximum threshold placed on index gains. If the index gains 10% but you have a 6% cap, your account gets credited at 6%. 

Immediate and Deferred Annuities

The terms “immediate” and “deferred” refer not to the features of the annuities but to when the annuitant starts receiving disbursements from them. Deferred annuities grow with interest during the accumulation phase and begin to pay out at a specified date in the future, whereas immediate annuities start paying out soon after the annuitant makes a lump-sum contribution, skipping the accumulation phase. Whether you purchase a fixed, variable, or indexed annuity, you can opt to make it either immediate or deferred.

Important Factors To Consider When Choosing an Annuity

In addition to understanding what the different types of annuities are, it’s crucial that you consider the following factors when choosing an annuity for your retirement portfolio:

• Your financial goals: If your goal is to maximize the amount of money you have in retirement, then you may want to consider an annuity that offers greater upside potential, like a variable annuity. Otherwise, a fixed annuity may be the more dependable choice.
• Your time frame: Do you need the money soon, or can you wait while the account grows? In the case of the former, you may want an immediate annuity. In the latter, a deferred annuity could be the way to go.
• The amount of risk you’re comfortable with: Risk-averse buyers are likely to prefer fixed annuities, as they present little risk, whereas an experienced investor could do well with a variable annuity. If you’d like something in the middle, then an indexed annuity might interest you.

Remember, choosing the best vehicles for your retirement portfolio requires thorough knowledge and careful consideration. Make sure to speak with a financial adviser to ensure that you know exactly how a particular annuity aligns or clashes with your financial goals.