Variable vs. Fixed Annuity: Understanding Investment Income Types

What Is a Variable Annuity?

A variable annuity is a financial product provided by an insurance company and is designed to produce regular income for annuity owners. It is of particular interest to investors who put greater weight on income than growth. The return it offers can increase or decrease according to the market performance of the investments in which it's invested. So, variable annuities offer the possibility of higher returns but also the risk that the account will fall in value. The annuity owner selects the annuity's portfolio of investments.

A fixed annuity is another income-producing investment option. In contrast to a variable annuity, it guarantees investors a fixed return.

In-Depth Look at Variable Annuities

A variable annuity is created by a contract agreement made by an investor and an insurance company. The investor makes a lump sum payment or a series of payments over time to fund the annuity, which will begin paying out at a future date.

There are many choices available to the investor. The payments can continue for the life of the investor or for the life of the investor or the investor's surviving spouse. It also can be paid out in a set number of payments.

One of the other major decisions is whether to arrange for a variable annuity or a fixed annuity, which sets the amount of the payment in advance.

Mechanics of Variable Annuities

In a variable annuity, the amount of each payment varies based on the performance of an underlying portfolio of sub-accounts. Sub-accounts are structured like mutual funds, although they don't have ticker symbols that investors can easily use to track their accounts.

With a variable annuity, payment amounts depend on the investor's initial payment (principal) and the returns from the annuity's investments.

The most popular type of variable annuity is a deferred annuity. Often used for retirement planning purposes, it is meant to provide a regular (monthly, quarterly, or annual) income stream, starting at some point in the future.

There are immediate annuities, which begin paying income as soon as the account is fully funded.

Annuities can be purchased with a lump sum or periodic payments, allowing the account value to grow. For deferred annuities, this is a phase known as accumulation.

The second phase is triggered when the annuity owner asks the insurer to start the flow of income. This is referred to as the payout phase. Some annuities will not allow you to withdraw additional funds from the account once the payout phase has begun.

Variable annuities should be considered long-term investments due to the limitations on withdrawals. Typically, one withdrawal each year is permitted during the accumulation phase.

Withdrawing during the surrender period, which can last up to 10 years, usually incurs a surrender fee.

As with retirement savings plans like individual retirement accounts (IRAs), the investment growth in the account is not taxed during the accumulation phase. As with IRAs, withdrawals before the age of 59½ will result in a 10% tax penalty as well as taxes due.

Comparing Variable and Fixed Annuities

Variable annuities were introduced in the 1950s as an alternative to fixed annuities, which offer a guaranteed—but often low—payout during the annuitization phase. (The exception is the fixed income annuity, which has a moderate to high payout that rises as the annuitant ages).

Variable annuities like L share annuities give investors the opportunity to increase their annuity income if their investments thrive. They can invest in their choice of a menu of mutual funds offered by the insurer.

The upside is the possibility of higher returns during the accumulation phase and a larger income during the payout phase. The downside is that the buyer is exposed to market risk, which could mean losses.

With a fixed annuity, the insurance company assumes the risk of delivering whatever return it has promised.

Pros and Cons of Variable Annuities

In deciding whether to put money into a variable annuity vs. some other type of investment, it’s worth weighing these pros and cons.

Below are some details for each side.

Advantages

1. Variable annuities grow tax-deferred, so you don’t have to pay taxes on any investment gains until you begin receiving income or make a withdrawal. This is also true of retirement accounts such as traditional IRAs and 401(k)s.
2. You can tailor the income stream to suit your needs.
3. If you die before the payout phase, your beneficiaries may receive a guaranteed death benefit.
4. The funds in an annuity are off-limits to creditors and other debt collectors. This is also generally true of retirement plans.

Disadvantages

1. Variable annuities are riskier than fixed annuities because the underlying investments may lose value.
2. If you need to withdraw money from the account because of a financial emergency, you may face surrender fees. Any withdrawals you make before age 59½ may be subject to a 10% tax penalty.
3. The fees on variable annuities can be quite hefty.

The Bottom Line

Variable annuities are complex financial products. If they interest you, it's important that you understand the details of a variable annuity contract, including the underlying investment choices and the potential risks and rewards, before you buy. The prospectus can provide you with this information.

Compared to fixed annuities, variable annuities offer the potential for greater return but higher fees and greater risks of loss of value, as well. Their numerous expenses—such as investment management fees, mortality fees, and administrative fees—and charges for any additional riders, can quickly add up.

As with any investment, expenses can adversely affect your returns over the long term. So take the time to carefully consider whether variable annuities are right for your financial goals.